Valuations are an integral part of finance. In order to make an investment decision, it can be useful to ‘value’ a company to determine its current value and what its future value may be depending on news and growth. An undervalued company might be a good investment whereas an overvalued company would be avoided.

The typical valuation frameworks (e.g. Discounted Cash Flow, Multiples and others) cannot be used in the crypto space because the vast majority of companies are start-ups and we don’t have access to the data that makes these valuation techniques possible. In addition, Cryptocurrencies rely on a completely different set of fundamentals compared to traditional equities. In addition, because of the diversity of types of cryptocurrencies, a single catch-all valuation framework cannot be created to cover everything.

The Different Kinds of Cryptocurrencies

In a previous post, I described a framework for categorizing the different kinds of cryptocurrencies. I split the different cryptocurrencies into the following six categories:

1) Cryptocurrencies

2) Platforms

3) Utility Tokens

4) Tokenized Real Assets

5) Cryptosecurities

6) Hybrids

In this article, I will suggest a framework that can be used to value utility tokens.

What is a Utility Token?

These coins are required to perform a specific action in an ecosystem run by the coin issuer. They are generally built on top of an existing blockchain such as Ethereum. This is the largest class of tokens now being built in the crypto space.

Example: Civic

Civic (Ticker: CVC) is an identity management service that allows you to protect and authorize the use of your identity in real-time. The Civic token is used to perform actions in the Civic ecosystem. It will be able to purchase identity services and is offered as an incentive for validators.

Example: 0x

The 0x (Ticker: ZRX) token allows users to exchange different types of ERC20 compliant tokens (all tokens issued on the Ethereum blockchain are ERC20 compliant). Users must pay the transaction costs using ZRX tokens.

Valuing Utility Tokens

Utility tokens are similar to existing fiat currency (e.g. USD) with the exception that a token can only be used for a specific action. US dollars can be used to buy anything (e.g. food, transportation). Conversely, a token issued by a café could only be used to buy services in that café.

Case Study: Café Tokens

Suppose there were 1000 tokens issued by the café for all customers to buy coffee. No further tokens would be created. Prices in the café are priced in fiat currency, but must be paid in tokens. There is an exchange rate between the café tokens and fiat currency that fluctuates based on demand. During an ICO, the café sells the tokens for $1 each. A coffee is priced at $3, which costs 3 tokens. The café then becomes more popular. As customers must use tokens to purchase the coffee, the law of supply and demand says that the token price must increase because the supply is fixed, but the demand is increasing.

While the price is fixed at $3 in fiat currency, the token price will fluctuate based on demand. After a few days when the café gets popular, the token price increases for $2 per token. The cost of a coffee is now 2 tokens and the total supply of tokens becomes worth $2000. Speculators who purchased tokens because they had faith in the Café’s business model can sell at a profit to those who want to buy coffee.

There are three factors that affect demand for utility tokens:

1) Demand to perform an action in the ecosystem: If a user wants to buy coffee from the café, they will need to buy tokens first

2) Speculation: If a user thinks that many other people will buy coffee from the café, they may buy tokens because they believe the price will rise. They don’t want to buy coffee.

3) Other Characteristics: The café tokens offer voting rights to determine what kind of future products should be served in the café. Only token holders can vote in these elections. This factor cannot be used to easily determine the fair value price of a token as voting may be of value to some, but not others.

The Current State of Utility Tokens

The factor that is currently driving utility token prices is #2 — speculation. Most of these projects are start-ups and thus there is currently very little demand for tokens to be used for their intended purpose. Instead the market is filled by speculators who are betting on the project’s future potential.

For example, 0x has a live product and a few exchanges are built on the 0x protocol. There is a helpful website that tracks ZRX fees called 0x Tracker. On this website we can see that for the past seven days, fees have ranged $1.16 TO $11.69 of value. This represents ALL fees paid in ZRX for a day. This is a puny number and does not justify 0x’s $96 million market cap. Most of the value of 0x’ market cap is thus from speculation about the future potential of the token.

How do Venture Capitalists Value a Company?

Perhaps looking at venture capitalist valuation techniques might be useful to value a utility token? But are they applicable to ICOs? Are they applicable to tokens in general? Below are a few characteristics VCs look at and how they could be used to value the true value of a token.

Comparables:

This technique uses the value of a similar company to make a valuation. In the startup space, the perfect example would be Lyft and Uber. However since all blockchain startups are new, how can this technique be used effectively? Can we compare Cindicator and Enigma to derive a token value? No — we cannot. These projects are all too early stage for any sort of meaningful analysis.

Market Perception:

In the days of the dot com bubble, venture capitalists were salivating to get their cash into any company with a .com ending. This still happened even with the dubious business plans and fundamentals of these companies. Remember Pets.com? This was ok as long as they could exit their investment at a profit. For a while a frothy market allowed this — until it popped. ICOs were in this stage until early September when the China news was announced. This news deflated the bubble somewhat, but there is still much interest from crypto funds in ICOs at this time.

Quantitive Methods:

Any sort of quantitative method can only be used for a company that has some revenue. Even projections are pure guesswork. However, as noted repeatedly, the vast majority of ICOs are for projects without even a work product! There is little reason to use a quantitative method when there are no numbers to work from.

Qualitative Methods:

This is really the only way that most projects can be evaluated at the moment. A business plan, a white paper that describes how the token will be used, and a team’s pedigree is what most projects can be judged by.

Conclusion

While there are theoretical ways to value utility tokens (e.g using the law of supply and demand as outlined above), until there is more data available, any valuation will be subject to guess work. Depending on an analyst’s view of a project — completely different valuations could be obtained. It is scarcely even worth trying to quantitatively derive token prices without any underlying data. The best way to look at the value of utility tokens is to look for quality projects with strong teams. These are the ones most likely to be successful in the long run.