Hello readers,
This week we’re providing a financial analysis of Ethereum.
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To be clear, this is sort of a non-starter. Ethereum is not a traditional growth company and will never look like one. We’re simply running through this exercise so that a traditional investor can use traditional frameworks for valuing an asset and then fit and adjust those frameworks when evaluating an asset like Ethereum.
Cryptoassets are difficult to grasp for traditional investors because they are “not like other things.” Most of us (usually unknowingly) use this framework to evaluate anything new that comes into our orbit. We want to find something from our past that we can relate the new thing to. If we cannot relate it to something we already understand, we often dismiss the new idea or concept. So, while Ethereum is not actually comparable to a growth company, we are going to walk through the framework that one might use to value a growth company and then compare it to Ethereum.
A dollar today is worth more than a dollar in the future. This has always been the case and will continue to be the case. Therefore, when investors analyze an investment opportunity, they must project out the future cash flows and then discount them (due to inflation as well as the opportunity cost of investing in an alternative asset) to get to the present value of the investment today. If that NPV is higher than the capital invested, the investment could be greenlighted.
Because Ethereum has significant cash flows, we can apply a similar framework when evaluating the asset. We’ll get to this later in the report.
Many analysts in the digital asset space are referring to Ethereum as a “triple point” asset. We could view Ethereum as a capital asset since it has significant cash flows. As mentioned, we can project growth and discount the cash flows like we would a stock, bond, or real estate.
Ethereum can also be viewed as a digital commodity. “Digital oil” if you will. To build, transact, play games, trade, anchor data, or earn yield, you’ll need some Ether, the native asset of the blockchain. This acts as the grease that allows the network to function.
Finally, with the changes to Ethereum’s monetary policy (moving to disinflationary or potentially deflationary) post PoS merge, we could view Ether as a store of value.
I cannot think of an existing investable asset that could meet all three of these criteria.
The Ethereum network is growing exponentially. Year-over-year cash flows were up over 1,000% from January 2020 to January 2021. And even with the recent sell-offs in crypto, Ethereum’s cash flows were up over 400% from January 2021 to January 2022. The typical growth for a traditional high-growth tech company might be in the 30-50% range.
So where are these cash flows coming from?
A typical growth company earns its revenues by providing a product or service. Apple sells computers and gadgets. The product or service for a public blockchain like Ethereum is its block space. This is where the revenues come from. For any user or company to access the Ethereum blockchain (block space), they must hold Ether, the native asset of the Ethereum network. Therefore, the value of Ethereum is driven by the demand for users to access the network. Want to build something on Ethereum? You’ll need some Ether to pay for that block space. Want to transact on Ethereum? You’ll need some Ether for that. Want to anchor data to Ethereum? You’ll need some Ether. Want to play a game, trade, or earn a yield? You’ll need some Ether. You get the point.
Traditional companies tend to grow linearly. They expand with new products or services over time. They add sales and marketing teams to drive revenues. But networks grow in very different ways. They can grow in all kinds of different directions. For example, demand for Ethereum comes from companies and developers building decentralized finance apps on the network. It comes from users accessing those DeFi apps. It comes from companies and developers building decentralized gaming apps on the network, and from the users of those games. It comes from companies like Open Sea building NFT platforms on the network. And from users accessing Open Sea to mint and trade NFTs. It comes from DAOs building on Ethereum and from users accessing those DAOs. This is just a small sampling of the demand for block space on Ethereum today. New use cases seem to pop up daily. So, when we think about the growth and scalability of a blockchain network, we need to understand that network effects make it such that growth can scale exponentially. And that is exactly what we are seeing.
Furthermore, due to the composability of open-source public blockchains like Ethereum, companies, and developers can build applications that simply “plug into” other apps and services already existing on the network. This is like throwing a match onto gasoline in terms of potential for growth. Take MetaMask for example. MetaMask is a crypto wallet used to interact with the Ethereum blockchain. Users can hold, send, receive, and swap cryptoassets using MetaMask. To deliver the functionality for users to swap assets using MetaMask, they simply plug into decentralized exchanges built on Ethereum. Metamask didn’t have to build those exchanges themselves. They simply plug into them. This allows MetaMask to scale at a disproportional pace and highlights the scalability of blockchains due to the composability that these open networks offer.
Source: Token Terminal
Over the last year, Ethereum has produced over $10.9 billion dollars of revenue. This is the total value that users paid to access Ethereum. To access Ethereum’s block space. Interestingly, this is also Ethereum’s net profit. This is where we get into the paradigm shift that blockchains represent. Because these are decentralized networks, the expense to use the network is revenue to those securing the network. This can be hard for folks to wrap their head around. As the network grows, more validators are incentivized to come onto the network. Validators are staking their Ether assets to validate transactions (providing a service to the network) and are paid fees to do so. *I’m referring to post PoS merge here.* More users seeking block space = more transactions = more fees = more validators are incentivized to come onto the network = increased security = more users seeking block space, etc., etc. This is the flywheel and how blockchain networks grow.
So, Ethereum does not have any expenses. The expenses are essentially the time that a decentralized network of developers devotes to building applications on the network. Users pay for access to that network. And the access fee is paid to long-term holders of Ether that have staked their assets to provide a service to the network - validate transactions and secure the network. You may read that and think that the network is just creating inflation to pay the existing Ether holders for validating transactions, hence devaluing the token base. This is not the case due to a change in the Ethereum monetary post PoS merge. Less Ethereum will go to stakers (as compared to miners) post PoS merge, and a portion of the fee is burned. It’s possible the Ethereum float (currently about 4% inflation per year) will turn deflationary due to these changes.
Keep in mind that this is also true of any application built on top of Ethereum. No expenses. The security expense is outsourced to Ethereum at the base layer - provided by the stakers. This is why apps built on Ethereum can grow and scale at lightning speed. They don’t have operating costs. No capital costs. No sales & marketing costs. Just a small team of developers devoting their time to building decentralized applications.
The visual below represents how this is a complete paradigm shift when compared to a traditional company. It shows the last twelve months revenue per employee of DeFi apps built on Ethereum vs a traditional finance company. Uniswap jumps off the chart. The Uniswap team has about 30 developers. The DEX is earning about $40 million per employee over the last year. This compares to about $300k per employee for the New York Stock Exchange.
Source: Ark Investment Management
Traditional companies have a centralized team building and selling products and services. Decentralized blockchains have a decentralized network of users and those providing services to the network. The users are paying the service providers, which could be anyone, anywhere in the world.
Source: Token Terminal
Ethereum’s P/E Ratio is currently about 34. Keep in mind that the price of Ether has been volatile lately. Revenues have been down as well. As mentioned, Ethereum grew over 1,000x from in 2020. And over 400x in 2021.
Compared to traditional growth companies:
So, Ethereum is growing at 4-10x the pace of these companies, has zero expenses, and yet looks undervalued when compared to most of them. Interestingly, the only growth company that looks undervalued is Coinbase, the only crypto company listed.
If we were to value the Ethereum network today based on the following inputs, we get a value of $10,615 per Ether.
Term: 20 years
Discount Rate: 12%
Average Growth Rate: 25% (Ethereum grew 400% last year and 1,000% the year before)
Here is a link to the DCF model that was put together by Ryan Allis, who writes the Coinstack newsletter. I suggest checking out the model and playing with the inputs as you choose.
Source: Ark Investment Management
Ethereum’s addressable market is massive. As we think about where this innovation is taking us, it is possible that all global financial services could move to public blockchains this decade. This is a $22.5 trillion dollar market. Of course, Ethereum has many smart contract platform competitors. These competitors are making trade-offs in terms of decentralization and security to enhance transaction throughput and reduce fees. As such, these platforms are taking some of the market share over time. While the alternative smart contract platforms like Solana and Avalanche are small today compared to Ethereum, we’ll be watching closely in the coming years to see how the market perceives the trade-offs they are making as well as the various L2’s.
Proof of Stake merge later this year. This is a massive change for Ethereum. If successful, it could enhance Ethereum’s value and use cases. But if there are complications or it fails, other chains will likely pick up market share from Ethereum.
Layer 2s. Ethereum now has many layer 2 scaling solutions that are also eating into its market share.
Alternative smart contract platforms. As mentioned, Ethereum sits in a highly competitive space. Will its network effect persist with more competitors stealing market share? This is very much an open question today.
Ethereum and other well-run crypto networks and applications are producing significant cash flows today. We could run a similar analysis on Uniwap (decentralized exchange), Aave (decentralized lending/borrowing), Nexus Mutual (decentralized insurance), etc. While these networks do not function like traditional companies, they produce cash flows and therefore we can run DCF analysis in an attempt to determine the appropriate value given the assumptions. As institutional investors start to pick up on this, it is reasonable to expect their $ to flow into these networks.
This is not a call to go out and buy some Ethereum. But if you are holding some, or thinking about buying some, this is hopefully a framework to help you think about what you are holding or planning to purchase.
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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general investment information only, is not individualized, and as such does not constitute investment advice.