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DAS London Preview: Valuation

EBITDA was discovered by John Malone.

He admittedly did not unearth it from a dig, like fossils of an unknown species of dinosaur — so maybe it’s more accurate to say that Malone “popularized” the now-ubiquitous valuation metric.

But he was the first financial pioneer to employ it at scale, and it’s probably not too much of a stretch to say that the discovery of EBITDA is what built the cable TV industry.

That’s because financial metrics are first and foremost a way to understand an asset — and EBITDA was a new one when Malone started telling investors it was how they should understand the earnings power of his cable and media company, TCI.

Cable was a new kind of industry, he explained, and understanding it required a new kind of valuation metric — investing in the capital-intensive cable industry would have made no sense to investors using traditional metrics like dividend yield, price-to-earnings or book value. 

It made plenty of sense, however, to investors willing to adopt Malone’s new EBITDA metrics, which allowed them to look past the staggering cost of building cable networks and envision a gusher of free cash flows at the end of their investment horizons.

Crypto is a different kind of industry, too — so, to understand it, we will need to discover some new valuation metrics.

DAS London will be a good place to start looking.

Fully Discovered Valuations

Intrepid crypto investors have already made one big discovery: “Fully diluted value” (FDV), the crypto metric commonly used in lieu of market capitalization.

I’d argue that it’s also commonly misused, possibly because “fully diluted” has a different meaning in crypto than it does in equities.

In equities, “fully diluted” is what a company’s share count would be if all company-issued options were exercised and all convertible securities were converted. 

In crypto, however, fully diluted is what the token count would be if every token that’s been created is released into circulation.

If that sounds like a distinction without a difference to you, consider that there is also something known in equities as “authorized capital”: The maximum number of shares that a company can legally issue, as specified in its articles of confederation.

Authorized capital is the FDV of TradFi, and using it as a valuation metric would make every company look astronomically expensive.

But companies rarely max out their authorized capital (AMC is a recent exception), so investors rarely think about it — “authorized capital” is not a metric anyone uses.

In crypto, however, a protocol is much more likely to release the maximum number of tokens into circulation, so FDV is much more applicable — and potentially useful.

A good trade might be to buy a token that looks cheap on market-cap metrics and expensive on FDV — if you believe that many of the tokens included in FDV won’t ever be put into circulation (and therefore will never be included in the market cap), the token may be far cheaper than it’s FDV suggests.

A good investment might be to buy a token that will release all of its tokens into circulation, but create a lot of value in the process — a token might look expensive on FDV only because we can’t yet see the value that new tokens will generate. 

How might releasing tokens create value?

Maybe the new tokens will be offered in airdrops that attract new users. Or maybe they’ll be spent productively on marketing. Or maybe developers will be incentivized to build new, money-making features.

Issuing tokens out of a protocol’s treasury might create value for token holders in the same way that Malone’s huge investments in cable infrastructure created value for his shareholders.

When people cite FDV metrics, they are implicitly assuming that all of that token issuance will be unproductive.

There’s a lot of unproductive token issuance in crypto, so, in most cases, those assuming the worst case scenario will probably be right. 

But not in every case.

Finding the exceptions — and avoiding the rules — will be what makes FDV a valuable discovery.

Eureka?

Crypto people tend to dismiss valuation as a meme and I get that. 

There is so far no correlation between valuation (however measured) and subsequent performance — cheap tokens don’t seem to go up and expensive tokens don’t seem to go down with any kind of predictable regularity.

But that’s not how things work in equities, either — if it did, this year’s big winners would be value investors long coal stocks and the big losers would be momentum investors long AI stocks.

(They’re not.)

The point of valuation metrics in equities is not just to buy the cheapest things. 

The point is to 1) better understand the business you’re buying into and 2) better understand why everyone else is buying into it.

Valuation metrics simply help us to know what we’re doing.

Malone sold investors on EBITDA as a metric because it was explanatory of what they were buying into: An industry that would consume huge amounts of investors’ capital in the short term and, with luck, return even more of it in the long term.

Similarly, we need new valuation metrics to understand what we’re buying into when we invest in this new asset class of crypto.

So far, the message from FDV to crypto investors is that they should be even more patient than Malone’s cable investors.

It’s a good start — the crypto equivalent of the 1824 discovery of the Megalosaurus in Oxfordshire, England.

We should be looking for more in London next week.

― Byron Gilliam

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