How to Value DeFi

The Oxford English Dictionary defines value as being, ‘worth or desirability or utility’. Price is defined as being ‘the amount of money expected, required or given in payment for something’. Ideally ‘value’ and ‘price’ are related to each other, but that need not be the case.

What is Value?

We need to carefully differentiate between various definitions and understandings of the word ‘value’ when thinking about valuations and prices. Sometimes people mean ‘cheap’ when they use the word value. Other times they mean that they particularly like some aspect of a good or service. Or they could mean that they are happy to pay a high price for something that they value.

Just like valuation itself the word ‘value’ is subjective. Value is something in the eye of the beholder.

Price v Value

Price, on the other hand, is something that is mostly objective. The price of Bitcoin, for example, might be A$60,000. Tomorrow it will be another price. But what is the value of Bitcoin?

Fama-Efficient Markets

A market where value and price are equal can be defined as being a Fama-efficient market. This is after the 2013 economics Nobel Laureate, Eugene Fama, who popularised the notion of informationally efficient markets. In such a market the prices that assets trade at reflect all information that could impact upon the valuation of that asset. In practice this means that prices react quickly to new value-relevant information. There is a huge academic debate as to the extent to which stock markets, for example, are Fama-efficient. But it is clear is that prices in stock markets do quickly react to news. Bond markets too.

Are Crypto Markets Fama-Efficient?

This is where things become difficult. In most asset markets we have a clear idea of valuation. We can think of the drivers of valuation even if we do not always agree what the correct value (or price) of an asset might be. So, for example, we might think that a share price should be the discounted value of future dividends. Or we might think that the share price should represent 5 times the current earnings per share. We might imagine that a bond should be valued at the discounted coupon value. Or that a call option should be valued by applying the Black-Scholes option pricing formula.

In the case of each of these financial assets, shares, bonds and options we have a valuation model that informs our evaluation of value and consequently the price we are prepared to pay for that asset.

In the case of crypto-assets, however, we do not (always) have a valuation model that can be used to think about the drivers of value. There is no cashflow associated with owning Bitcoin – so none of the discounted cashflow models is really appropriate for valuation. It is also not an option. If Bitcoin is money – as many argue – then maybe it could be valued as if it were a money. But even here, there are many, many theories as to the drivers of the value of money but they do not seem to capture the essence of Bitcoin.

All this leaves us in a difficult position  – we do not really know how to value many crypto-assets but they are traded in markets for a price. Are those prices ‘reasonable’? We cannot be sure. But that does not mean that we shouldn’t make an effort to understand the underlying business models that support those assets. Most crypto-assets will have a white paper and a development team and an articulated business model. Before investing in any crypto-asset investors should read the white paper, make sure they can understand the business model, determine that the development team is credible and generally do some due diligence work.

In time, norms and conventions and generally accepted valuation models will emerge and the drivers of pricing will be better understood. Until then, investors will need to do a lot more work when making investment decisions.