Most analysts and value investors will tell you the best and most robust way to value a company is through its cash flow. "Cash flow" can have multiple definitions, but the majority of investors lean towards free cash flow. This means earnings after expenses, capital expenditures, and taxes. There are several different calculations for free cash flow and various applications are depending on the company. For the sake of this discussion, we will use this formula:
Free Cash Flow= EBIT*(1-tax rate)+Depreciation and Amortization- Change in current assets-current liabilities - Capital expenditures(capex).
Accounting Jigsaw
The holy triumvirate of corporate accounting is the balance sheet, income statement, and cash flow statement. Each presents different information about a company's financial health at different points in time. From them, you can extract numbers useful in valuing a company. For instance, the income statement gives you earnings before interest and taxes (EBIT) to which you then apply the tax rate. The income statement provides figures for depreciation and amortization. From the balance sheet, you find changes in assets and liabilities, as well as company capital expenditures. All of these can be used to evaluate how much actual cash is being generated and is available. As an investor, you could evaluate what that cash flow is worth to you.
DCF
If I gave you $100 today, what would it be worth in 5 years? This is essentially the question a discounted cash flow model (DCF) looks to answer. To simplify, $100 which is growing at 10% is worth $110 in the future, while the present value of that $110 is $100. By doing this exercise we can look at what the value of a company is today given present and future cash flows, and we can also adjust for any future growth rates.
PE
The most well-known valuation method for equity investors is the Price to Equity Ratio which has a formula R=P/E where one divides the price of the stock by earnings per share(EPS). Earnings per share is total earnings divided by the number of shares, which looks like EPS= Total Earnings/Total shares outstanding. This number or ratio standardizes numbers so that you can easily compare different companies by their earnings. You can also flip this number to get an earnings yield, which looks like a return and is also useful for comparison. The magic of these ratios is that they allow you to solve the third number if you have the other two. For example, if you decide a proper valuation (PE) of a company by looking at its peers is 25x, 50x, or 100x, simply multiply by the earnings (P=R*E), which gives you the fair price value of a stock. The point is to find the quality of a company's earnings by comparing companies and applying a quantitative measure to it.
Simple enough, how about cryptos?
Digital assets are known as cryptos because of their cryptographic software and, both differ and resemble several other asset classes. Bitcoin is the best-known and uses a software protocol that rewards miners (computer nodes) to run the network. Because of the nuances of the protocol which runs Bitcoin's Proof of Work("PoW") software, traditional valuation metrics like DCF and PE are not applicable. The second-largest cryptocurrency is Ethereum and its network also runs on the Proof of Work network. Ethereum, however, intends to "fork"(change) to a full-time Proof of Stake protocol in Q4(?) The network has implemented a limited amount of staking since last summer to test the network and seems to be on pace for a full rollout. While "Pow" allows anyone with the correct computing power to gain rewards from mining and validating transactions, "PoS" rewards validation on its network to the people who run nodes and have bought tokens in the network. In this instance "PoS" looks a lot like an equity holder with the rewards to the network resembling earnings and dividends. More importantly, we don't have to break down the accounting measures because the number of tokens, like shares, is readily available and the amount of revenue paid to the stakeholders is comparable to free cash flow.
Starting from scratch, what we know
First, we know that Ethereum has a set number of tokens that we can evaluate like shares. We should also note the network intends to burn tokens in the future, which is similar to a stock buyback. Secondly, because Ethereum is on a blockchain, the data is available on how many tokens and the number of rewards are being paid out to the network in real-time. So let's break down the numbers with various scenarios and see if we can come up with a valuation.
Crypto is on a blockchain so it’s transparent
Ethereum has 118 million tokens or coins and a current value of $1,250, which in turn equates to a 150 billion market cap. Comparing market caps can be useful in comparing companies and how markets compare in size. The token holders will receive payouts (called gas fees) for validating transactions according to their percentage of ownership. For sake of simplicity, think of the fees Visa collects for transactions, a Ticketmaster processing fee, or even the amount of natural gas a company would pay to move its product along a pipeline. The current daily run rate for the Ethereum network is 15mm and crypto never sleeps (7 days a week). According to data on Glassnode, roughly 7,500 ETH on average is paid daily to the network while the current price is $1250. This would in turn be an annualized rate of 9.5 billion of revenue paid out to the network. We can then calculate the EPS (or token) of $80 and a PE of 15.5 given the $1250 price of Ethereum. This is where discretion is used for price prediction on what we believe people will pay for a token on the Eth network. For example at 25x Eth value would be $2000, 50X 4,000 and 100x ETH would be worth $8000. Tesla trades around 100x and many high-growth tech stocks would trade at even higher multiples. To make another relative comparison, we could invert the PE to E/P( or divide PE by 1) which would give us a yield of 6.45%. Looking at yields is an effective comparative tool as well as earnings yields and market caps.
Back to the Future-DCF
So now that we have established a baseline revenue for the year 2022, we can start to make some assumptions to determine cash flow out to 5 years which is called a terminal value. We will make assumptions about growth rates and discount the cash flows to the present value as we spoke about earlier. Applying a discount rate can at times be difficult and arbitrary. With established companies, you can use the cost of capital or debt and even the risk-free rate (US short-term treasuries). However, Ethereum with its staking mechanism makes for a different comparison than an established company that pays dividends. A company's ability to raise money is a reflection of the risk involved as a lender or a stakeholder and is determined by the rate the investor demands. We should apply an appropriate investor rate to properly evaluate the risk and rewards. Given that Ethereum Network is an emerging technology and the token’s price has a lot of embedded volatility, a discount used by venture capital (new business) makes for a good comparison (17.5%). So if we expect 2022 fees paid to the Ethereum network to be 9.5 billion, we can then forecast the cash flow for the following four years by expecting growth rates of 20pct, 20 pct, and 10 pct for the last two years. We then add all these cash flows and discount them back by 17.5% to get the present value of cash flows out to 5 years of $38 billion. Because we believe these returns to continue well past 5 years we would put a “Terminal Value” to these cash flows in the form of an exit multiple (what someone would pay for these cash flows). Putting a 15x Terminal Value to this gives a value of $574 billion which could be seen as Enterprise Value. We can then divide this number by the number of tokens 188 million gives us a value of $4,862.85 per token.
Conclusion
Price to earnings, earnings yield, market caps, and discounted cash flows are the most common tools for the valuation of companies and stocks. These tools seem to apply to blockchain networks that are on "POS" protocols like the Ethereum Network. Like any model, the input assumptions are what drive the effectiveness of price prediction. While I have been extremely conservative with the current run rate as well as growth predictions, these valuations seem to put a floor at 1,000$ while forecasting growth could be much closer to 10,000$. When you consider nominal growth, while taking into consideration the current bear market in cryptos, Ether's token value looks to be fairly valued at around $4,500 given these various valuation tools. While cryptos are a new and emerging asset class, traditional finance continues to be the most important tool in the analyst and investor kit.
Notes:
not financial advice
no costs are associated with the Ethereum network so the fees to the stakeholders and the revenues look more like earnings
while conservative with my estimates, a better blockchain or layer 2 protocol could siphon off fees. Ether gas fees have been problematic at times being too high, its assumed lower transactions fees are most likely in the future but will be offset by network growth
revenue growth is assumed by more demand for the network and more projects built upon the Ethereum Network which implies more value to the network, click on the link for a great explanation from Thaisa Fernandez https://medium.com/pm101/metcalfes-law-and-why-you-should-keep-it-in-mind-9a3b217226fc
The Board unanimously decided to add a project to its technical agenda that will address the recognition, measurement, presentation, and disclosure of certain digital assets in the financial statements.
The project is expected to focus on whether to require or permit ongoing fair value measurement for digital assets with specified characteristics.
Why is this important?
There is no specific reference to BTC or digital assets under the current accounting measure, so these assets fall into the bucket of “intangible assets”. In other words, these assets fall into the murky valuation of non-physical assets like intellectual property and branding.
What does that look like?
Accounting for BTC is put on the books at the purchase price which is obvious. However, if BTC goes below the purchase price the company must write down the value as an impairment charge. If the price goes higher, the value remains at the purchase price and only can log any gains when they sell and create a taxable event.
Updated: Mar 1, 2022
How did we get here?
The OPEC oil crisis of the 70’s shocked the United States and the world, as cheap reliable oil suddenly became an economic and sovereign security problem. The consortium of oil-producing countries, which had formed in 1960 under the name OPEC, cut exports in 1973 to western countries who had supported Israel during the Yom Kippur War. Countries like the USA, Great Britain, and Japan who had all relied on cheap oil to support their economic worlds, were left vulnerable as these Arab oil-producing nations leveraged their commodity influence, resulting in a four-fold increase in prices. The oil embargo of “73–74”, which produced high prices and gas station rationing, put the world on notice that reliable energy was no longer a given. This made energy, not only an economic issue, but one of sovereign security. The inevitable result was an increased domestic production from the United States as well as the UK. Multi-national energy producers now found previous expensive oil and gas reserves as viable under the new pricing regime. Energy companies were able to extract offshore drilling sites in the North Sea for Brent, crude oil exploration in Texas, the Gulf of Mexico, and as well as the Alaska oilfields. This was seen as a way of owning production, reducing reliance on the Middle East, and another engine of economic prosperity. However countries that owned little reserves of fossil fuels like Japan, France and South Korea, still remained vulnerable by importing most of their coal, oil and gas.
Harness the power of wind, water and the atom
The increasing demand worldwide for energy with the rising prices may have been the catalyst for alternative sources of energy and the first real movement towards “green energy”. The 1970s also brought the first realization that pollution and smog from coal and oil was not a sustainable path. This also coincided with mankind’s ability to “tame the atom” to harness energy. The future seemed to be bright for nuclear energy as the long-term solution for affordable and self-reliant energy. Technology finally seemed to provide "the magic bullet" to cheap and reliable energy through nuclear fission.
It’s Cold out there
The 1970s was the height of the cold war between the west and the communist regimes of the Soviet Union and China. The proliferation of nuclear warheads increased dramatically leading to the principle of “assured mutual destruction”. The advance of nuclear technology also brought the increased use of nuclear fission as a power source across the US, Europe, and the East.* France and the United States initiated nuclear programs for energy diversification while the Soviet Union and China embraced this energy as a source to keep the lights from going off.
The Future Derailed
In 1979 a film called the China Syndrome debuted in the United States starring Michael Douglas, Jack lemon, and Jane Fonda. The fictional movie focused on a nuclear power plant outside of Los Angeles that overheated causing the nuclear core to melt. The plot consisted of the belief that radioactive plutonium would melt through the core of the surface of the plant, leak through the earth's globe and come out to the other side of the world in China, therefore the name "China Syndrome". This idea of wholesale destruction, which looking back seems more akin to the popular disaster movies of the ’70s like “Earthquake” and “Towering Inferno”, never really articulates the risks and reality of nuclear energy. Arguably, this left an impression on the minds of people for decades and more importantly environmentalists and activists who linked nuclear power with contamination and destruction. Adding to this consciousness, twelve days after the movies debut and surely adding some free press, a small leak of radioactivity matter was released at nuclear plant Three Mile Island in Pennsylvania. In 1986 the Chernobyl nuclear plant disaster in the Soviet Union brought the reality of mass casualties from a nuclear accident. A tsunami in the Pacific in 2011 that struck the coast of Japan caused contaminated fuel to leak from The Fukushima nuclear plant. This seemed to cement the idea that nuclear energy wasn’t worth the risk. As the chart above shows, nuclear energy production peaked 20 years ago and has remained flat even as worldwide energy demand has increased. Alarmingly, 90pct of all US reactors were will built between 1970-1990, with many being decommissioned or soon to be.
Could the human race control nuclear fission as an energy source without wrecking the planet or having a devastative war? Nuclear energy's future seems to hang in balance as nuclear energy has decreased by half over the last twenty years of worldwide electricity production. This leads us to ask , are the risks genuinely assessed? More importantly are the rewards of clean energy not being properly calculated?
Carbon Footprint
When we discuss the term carbon footprint, it means how much carbon is released into the atmosphere from extracting, producing, shipping and the use of a energy source. All these points along the process should also be considered when assessing the risk of fatalities.
Given the chart above, when we account for accidents as well as death from air pollution, the risk-reward ratio doesn't correlate with our collective thoughts on power sources. What stands out is that hydro and nuclear provide the greenest and lowest carbon option of energy. It should be added that while the sun, wind and water don't always shine, blow, and flow, nuclear energy remains reliable. Isn't this the goal of society in 2022 when it comes to understanding energy and the health of the planet? This leaves us with the question of why are we dismissing nuclear energy and what does it's future look like?
Hanging Around
The longer an idea, a collective, or technology sticks around, the more likely it will exist in the future. This is known as the "Lindy Effect" and is an important concept in how we adopt and accept ideas or technologies. We have been capable of harnessing nuclear fusion for 70 years, which according to the “Lindy Effect” should be a viable technology for the next 140 years. The Lindy Effect states that technology or an idea tends to exist twice as long as its existence. So does this mean nuclear fission is here to stay and what does that mean for nuclear fusion which has been around for 4.5 billion years powering the sun? Given this principle, nuclear energy will be part of the future and only time, money and effort will dictate when it becomes more prevalent.
Fusion or Fission HUH?
Simply put, fission is splitting of an atom
(a heavier element like uranium and plutonium) and harnessing the energy in what we know as nuclear fission. It has survived all the negative issues and still remains a source of energy across the globe. It remains the prime source of power in France and has also been a mainstay for the US Navy, as they have safely harnessed nuclear fission for ships and submarines. Unfortunately, the by-product of splitting atoms is radioactive waste which is toxic to all life. It’s arguable that this radioactive waste can be contained and controlled because the total of all the waste so far produced since 1950 could be contained roughly in the size of an Olympic pool. The spent elements from fission are highly radioactive and can be dangerous to life in the air, land, or water. This ,and the promise of abundant elements, are key reasons why researchers are still working so diligently and quietly on nuclear fusion as the next great source of energy. Fusion is the combining or smashing together of atoms, as opposed to splitting them which is done with fission, which creates heat and thus energy. Nuclear fusion uses lighter elements like hydrogen and helium, which means the source can be harvested from sea water, unlike the heavier elements that need to be mined. Does fusion work? If you look up in the sky, there is a great ball of helium fusion sending heat and energy towards us every day. So where are we when it comes to nuclear fusion? The joke among nuclear physicists is that "fusion is almost ready in 30 years". The problem of fusion lies in the energy input being higher than the output, making fusion a non-viable source of energy at the moment. However there are projects in France** and in the US, spun out of MIT Labs***, continuing to work on the problems to make fusion a viable energy source. Once built, the promise of abundant, cheap, reliable and a non-toxic energy sources would render carbon-based energy like oil, coal, and gas as less critical.
The promise of Green Energy
Remedies on how to remove or curtail man-made carbon released into the atmosphere have been a hotly debated issue. Ironically, the one source that may be the least carbon-intensive and dependable, goes largely ignored. Even more confusing is the lack of funding for nuclear technologies while wind, solar and carbon capture enjoy increased funding. Why have we not built more fission reactors while funding and waiting for advances in fusion reactors? Perhaps it’s the large initial cost of building a reactor, the insurance cost or the inevitable “not in my backyard”, which turns out to be a political hot potato. There might be a fear that enriched uranium or plutonium could be weaponized and fall into the wrong hands. The biggest obstacle to the greater use of nuclear energy most likely is the terrible public relations and marketing in explaining the green benefits, while soberly addressing the risks involved.
At the very least, there should be more conversations on the topic between scientists, politicians and the public. Or perhaps, the industry which has demonized for the past 40 years, just needs rebranding.
With this in mind, I submit for consideration, a new marketing campaign: “Green and Carbon Free Fission and Fusion”.
