An Update of our Cryptoasset Valuation Frameworks and Portfolio Allocation Strategies: Q3 2023

Link to our State of Crypto on Portfolio Allocation: https://21shares.com/research/state-of-crypto-6

Link to our State of Crypto on Valuation Frameworks: https://21shares.com/research/state-of-crypto-7

Link to all of our on-chain dashboards: https://dune.com/21co

TL;DR

• There are two main valuation methodologies: There are two broad types of valuation approaches: (1) Fundamental or Intrinsic valuation composed of the Discounted Cash Flow (DCF) method and Mining Production Cost. (2) Relative valuation composed of Multiples and Market Sizing.
• Valuation methods depend on the type of cryptoassets: Both fundamental and relative valuations can be applied to all cryptoassets but should differ and adapt to the type of consensus mechanism: Proof-of-Work (like Bitcoin) versus Proof-of-Stake (like Ethereum).
• Bitcoin’s intrinsic valuation: We estimate the floor price of Bitcoin using the Mining Production Cost. In addition, we use relative approaches like market sizing and multiples to value Bitcoin. As of September 30, 2023, the estimated lower-bound average cost to mine one BTC is $18,771.5, while the upper-bound cost is $31,285.8, depending on several capital expenditures, especially the cost of electricity.
• Ethereum’s intrinsic valuation: We can value Ethereum using an intrinsic valuation with a discounted cash flow (DCF) method. Assuming a discount rate of 9.09%, one Ether (ETH) would be valued at ~$4,293, a ~157% increase from ETH’s price ($1,668) as of September 30, 2023. On the other hand, if we use a 21.90% discount rate, the implied price per one ETH would be ~$1,090, down ~35% from ETH’s price at the end of Q3. Investors should interpret the results of this DCF valuation with caution and run their own assumptions regarding projected cash flows and discount rates. The rationale behind the discount rate is to capture the investor’s expected rate of return based on the asset’s riskiness, as measured by its volatility. For the lower-bound discount rate, we used the compounded rate of return of the Nasdaq-100 in the past 10 years. For the upper-bound rate, we used the Fama and French three-factor model.
• Challenges for cryptoasset valuations: We aim to provide investors with the right tools to value this asset class, as there is no objective measure of value for cryptoassets today. Investors should understand the challenges and nuances of digital asset valuations to navigate this innovative and burgeoning asset class.
• Portfolio allocation: Adding Bitcoin and Ethereum to a diversified portfolio may provide diversification benefits due to their low historical correlation to other traditional asset classes. In our study, a 5% BTC allocation improved overall performance across all rebalance frequencies, improving annualized returns from 6.09% to double digits range (from 10.87% to 27.64%) and enhancing the Sharpe ratio from 0.45 to the 1.03 level. In addition, a 1% BTC and ETH allocation also improved overall performance. Adding just 1% constant bitcoin allocation reduced annualized volatility across all rebalance frequencies (expect no rebalancing) from the 13.51% benchmark to 13.22%. Meanwhile, a quarterly ETH rebalancing achieves the same volatility as the benchmark portfolio (15.54%) while improving the Sharpe (0.26) and Sortino (0.84) ratios.

Background

In 2022, we published two groundbreaking reports on our insights into cryptoasset portfolio allocation and valuation frameworks. Our State of Crypto Issue 6 provided data on optimizing crypto portfolio allocation for various risk profiles and portfolio strategies based on blockchain indicators assessing market sentiment. Namely, buyers' and sellers' cost of capital or cost basis relative to the current price of Bitcoin. The following edition of our magazine, Issue 7 provided our insights into fundamental and relative valuation frameworks for each type of cryptoasset. Every quarter, we will present an updated report with our latest valuation estimates and portfolio allocation figures. However, before diving into the data, why are these topics important?

• Valuation in crypto remains an emerging topic seeking consensus, especially as the asset class expands in use cases. Rober Greer, author of “What is an asset class anyway?” argues that assets that lack an objective measure of value and have a constraint on supply are more vulnerable to irrational exuberance, citing the dot-com bubble as an example. Cryptoassets lack an objective measure of value today among investors, similar to emerging tech companies in the late 1990s. Our goal is to propose valuation standards that reconcile different approaches investors have taken in recent years.
• Optimal cryptoasset portfolio allocation can lead to superior risk-adjusted investment returns due to their unique property of having largely unrelated risk premiums compared to all other asset classes. Rebalance is critical for portfolio construction to smooth out those big swings across major asset classes, especially for cryptoassets, including Bitcoin and Ethereum, and harvest the long-term premium with diversification benefits. With this in mind, it seems reasonable to explore adding digital assets to portfolios with different rebalance frequencies.**

Coverage

• Fundamental valuation: Ethereum DCF and Bitcoin mining cost of production.
• Relative valuation: Market Cap-to-Total Value Locked, Network Value-to-Transactions ratio, Market Cap-to-Thermocap ratio, market sizing.
• Portfolio allocation: correlation matrix and different rebalancing frequencies with 5% and 1% BTC allocation.
• Conclusion

Fundamental Valuation

• From the standpoint of a validator, PoS cryptoassets like Ethereum are akin to a stock that pays an annual dividend yield (the "staking yield") in return for securing the network and validating on-chain activity.

• In practice, the marginal cost of production is vital for crypto-commodities (PoW cryptoassets like Bitcoin), as it sets the price floor at which producers (miners) are willing to sell.

DCF Valuation: Ethereum

1 . Estimate the cash flows during the life of the cryptoasset

To measure Ethereum’s intrinsic value, we need to 1) estimate the asset’s cash flows, 2) forecast expected future cash flows and the lifespan of the asset, and 3) compute the net present value (NPV) based on a given discount rate.

• a. Transaction fees perceived by validators (after the burn mechanism) from September 30, 2022, to September 30, 2023, amounted to $355.01 million.
• b. Token Issuance from September 30, 2022, to September 30, 2023, amounted to $1.17 billion.
• c. Total Cash Flows: a + b = $1.52 billion in the first year.

2.  Estimate expected future cash flows and the lifespan of the cryptoasset. We proposed a three-stage growth model: 1) aggressive growth in the early years, 2) incremental decrease of unprecedented growth, and 3) stabilization.

Figure 1: Ethereum three-stage growth model

Source: 21Shares

3. Estimate the discount rate to apply to these cash flows to get Net Present Value (NPV).

• *Lower-bound discount rate (9.90%):* In the past 10 years, the Invesco QQQ Trust ETF obtained a 9.90% compound annual return.
• *Higher-bound discount rate (21.90%):* Obtained using the Fama and French Three-Factor Model (market premium, size premium, and value premium).

Figure 2: Ethereum DCF valuation

Source: 21Shares

• Results: Assuming a discount rate of 9.09%, the implied price per one ETH today would be ~$4,293, a ~157% increase from ETH’s current price ($1,668). On the other hand, if we use a 21.90% discount rate, the implied price per one ETH would be ~$1,090, down ~35% from ETH’s price at the end of Q3. Investors should interpret the results of this DCF valuation with caution and run their own assumptions regarding projected cash flows and discount rates. The rationale behind our approach was to be conservative and capture the high volatility of ETH in the discount rate to accurately reflect the asset’s riskiness. Another implicit assumption of this approach is that the asset’s monetary premium (Store of Value) is embedded into the DCF.

Mining cost of production

• In 2019, Charles Edwards proposed a methodology to estimate the global average US dollar cost of producing one BTC. The mining cost of production is analogous to the "All-In Sustaining Costs" (AISC) for gold, a measure, defined by the World Gold Council, as the cost of sustaining current mining operations.
• The marginal cost of production is a tool that can help investors estimate a lower bound price level for BTC and other crypto-commodities.
• When the BTC price is below the total cost of mining one BTC, it signals that Bitcoin miners may be financially struggling, on average, and potentially taking short-term losses.
• Since we published our update on valuation frameworks in Q2 2023, the average electricity cost to mine one BTC has decreased 10.46% from ~$20,965 on June 30, 2023, to ~$18,772 as of September 30, 2023, according to the Cambridge Bitcoin Electricity Consumption Index (CBECI).

Figure 3: Bitcoin mining cost of production

Source: 21Shares, data as of September 30, 2023

• Results: As of September 30, 2023, the estimated lower-bound average cost to mine one BTC is $18,771.5, while the upper-bound cost is $31,285.8, depending on several capital expenditures, especially the cost of electricity. Investors shouldn’t interpret this range as the fundamental value of Bitcoin, which is subjective, but rather as an estimate of its price floor based on miner profitability and subsequent behavior patterns. One of the caveats of this metric is the exclusion of non-cash expenses like depreciation and amortization — and the efficiency of supercomputers also called ASICs, which could impact the overall profitability of miners.

Relative valuation (Pricing)

• A significant portion of equity valuations in traditional finance consists of relative valuations based on multiples and comparables.
• In this section, we will explore two “multiples”: the Network-Value-to-Transaction (NVT) Ratio and the Market Cap to Thermocap Ratio.

Figure 4: Relative valuation based upon multiples

Source: 21Shares

Market Cap-to-Total Value Locked (TVL) Ratio

• In decentralized finance (DeFi), total value locked (TVL) is a crypto-native metric that investors can use as a proxy for assets under management (AUM). Hence, an ingenious pricing approach is to represent the market value of a smart contract platform like Ethereum as a multiple of TVL. We should clarify that TVL in our exercise includes Ethereum’s base chain and scaling platforms (Layer 2s).
• The results show that investors are pricing ETH at a premium relative to historical levels. A plausible explanation is that activity has dropped relative to the period of euphoria we experienced during 2020 and 2021.
• We should also note that a flaw of this metric is that TVL does not necessarily translate to higher profits. Thus, this multiple is only appropriate to the extent that TVL can effectively influence the protocol’s ongoing and future profits.

Figure 5: Ethereum’s Market Cap-to-TVL-based implied price

Source: 21Shares

Network-Value-to-Transactions (NVT) Ratio

• The Network-Value-to-Transactions (NVT) Ratio measures the dollar value of on-chain transaction activity of a given protocol relative to its Network Value.
• Per Glassnode, NVT can be interpreted as the inverse of monetary velocity, comparing Bitcoin’s two primary value propositions: Store of Value (Market Cap) and  Settlement/Payments Network (Transfer Volume).
• The results suggest that investors are currently pricing BTC at a premium, as market cap growth is outpacing on-chain transaction volume relative to historical levels. A plausible interpretation is that the Store of Value component of BTC predominates in recent times over BTC’s value proposition as a payment network.

Figure 6: Bitcoin’s NVT-based implied price

Source: 21Shares, Glassnode

Market Cap to Thermocap Ratio

• “Thermocap” is the cumulative sum of USD block rewards paid to miners. It can be interpreted as the total security spent by miners. Figure 7 shows that a high market cap compared to total aggregate security spent has historically been an indicator that BTC is relatively overvalued and near the top of a market cycle. Conversely, a low market cap to Thermocap ratio has historically signaled that BTC is relatively undervalued and near the bottom of a cycle.

Figure 7: Market Cap to Thermocap Ratio (July 2010 - September 2023)

Source: 21Shares, Glassnode

• Results: Investors can use the market cap to Thermocap ratio to assess if the asset’s price is currently trading at a premium to the total security spent by miners. Bitcoin is currently trading within its “fair value” compared to the historical market cap to Thermocal ratio.

Figure 8: Bitcoin’s implied price range based on Market Cap to Thermocap

Market Sizing

• Investors cannot value store-of-value assets intrinsically because their value is primarily determined by the subjective beliefs of many individuals. Thus, we can utilize a simple market sizing approach to estimate a target price. The methodology involves establishing a Total Addressable Market (TAM), and a percent share the asset in question could take — Market Penetration. For instance, an investor could price Bitcoin by setting a proportion it could capture of the market value of gold, the seminal store-of-value asset.
• Results: As of September 30, the price of BTC is $26,970, with an implied circulating market cap of ~$526 billion. On the other hand, the market cap of gold sits at around $12.12 trillion. Thus, we can use the market sizing methodology described above to estimate the hypothetical price of BTC if it were to capture a given percent share of gold’s market cap. For instance, Figure 9 shows that if BTC were to capture 10%, it would be priced at $59,908. In the most optimistic scenario contemplated, if BTC penetrates 30% of gold’s market cap, the price of one BTC would be $179,724.

Figure 9: Hypothetical value of BTC as a % of gold’s market cap in 2027

Source: 21Shares, Data as of September 30, 2023.

Methodology improvements – Crypto’s S-Curve

• One way to more accurately gauge a given cryptoasset’s level of penetration of its TAM is through the “S-curve.” The S-curve is a theory that states that technologies grow and emerge in multiple waves. It was initially proposed by E.M Rogers in 1962 as the Diffusion of Innovation (DOI) Theory to explain how, over time, a new technology gains momentum and spreads through a specific population or social system.

Figure 10: S-curve and the Diffusion of Innovation Theory

Source: Design by 21Shares

• There were 425 million crypto users globally at the beginning of 2023, representing about 5.31% of the world population.
• The level of crypto adoption today is equivalent to internet adoption in 1999-2000.

Figure 11: S-curve, crypto adoption compared to internet adoption

Source: 21Shares, Data from Internet World Stats, Statista, Crypto.com

Portfolio Allocation

Correlation of returns across asset classes

In Figure 12, we compare the correlation of returns for several major asset classes, represented by popular exchange-traded funds (ETFs), as well as Bitcoin (BTC) and Ethereum (ETH). The ETFs chosen represent a variety of asset classes and risk profiles and are as follows:

• US Equity, represented by SPY – The SPDR S&P 500 ETF
• Developed Equity, represented by EFA – The iShares MSCI EAFE ETF
• Emerging Equity, represented by EEM – The iShares MSCI Emerging Markets ETF
• US Bond, represented by AGG – The iShares Core U.S. Aggregate Bond ETF
• US Long Term Treasury, represented by TLT – The iShares 20+ Year Treasury Bond ETF
• Real Estate, VNQ – The Vanguard Real Estate ETF
• Gold, GLD – The SPDR Gold Shares ETF
• ARK Innovation, represented by ARKK

Bitcoin’s correlation with major asset classes ranges from 0.00 to 0.27 (excluding Ethereum), a similar level to what Gold (GLD) offers ranging from 0.06 to 0.23. This level of correlation made both assets a vital diversification source for traditional portfolios, which are a mix of equities and bonds. However, there is almost no correlation (0.10) between Gold and bitcoin, making both unique diversification resources for investors’ portfolios.

Figure 12: Correlation matrix

Source: 21Shares. Data: Bloomberg, Yahoo Finance (BTC). From 31/12/2014 to 30/09/2023.

Correlation of returns during distressed times

March 2020 (Covid Crash)

• During distressed times, asset classes tend to show an increased correlation. The stock market crash and liquidity crisis caused by the COVID-19 pandemic exemplify this pattern. Figure 13 shows that the significant and sudden global event that began in March 2020 and ended in April caused both BTC and Gold to undergo a sudden rise in correlation.
• Gold showed the lowest correlation during the crisis, although it’s crucial to note that BTC still exhibited a relatively low correlation to other asset classes, making it an attractive resource for diversification.

Figure 13: Correlation of returns during March 2020 (Covid Crash)

Source: 21Shares. Data from: Bloomberg and Yahoo Finance (BTC and ETH)

March 2023 (Banking Crisis)

• Bitcoin rallied 23.03% in March 2023 on the back of a looming banking crisis in the U.S. On March 13, the Federal Reserve had to step in to protect all depositors of Silicon Valley Bank, which experienced a bank run two days before, and of crypto-friendly Signature Bank, controversially shut down by its state chartering authority. Then, on March 19, UBS agreed to buy Credit Suisse in an emergency rescue deal brokered by Swiss authorities. Meanwhile, Figure 14 shows that BTC decoupled from risk assets like stocks and showed an increased correlation to Gold as investors turned to it as a hedge against bank risk.
• At its core, Bitcoin is a non-sovereign form of money that exhibits unique characteristics (trustless, permissionless, and censorship-resistant, among others). Indeed, one of Satoshi Nakamoto's primary motivations for creating Bitcoin was to have an alternative form of money outside central banks' control.

Figure 14: Correlation of returns during March 2023 (Banking Crisis)

Source: 21Shares. Data from: Bloomberg and Yahoo Finance (BTC and ETH)

Portfolio with different rebalancing frequencies

5% BTC allocation

We tested six types of rebalancing strategies by adding 5% constant bitcoin allocation to a simple growth portfolio (US Equity – 60%, US Bond – 40%): daily, weekly, monthly, quarterly, annually, and no rebalancing (see next slide). These are the key takeaways:

• Improved risk-adjusted returns: Adding crypto to an investor’s portfolio is noticeable with improved overall performance across all rebalance frequencies, improving annualized return from 6.09% to double digits range (from 10.87% to 27.64%) and enhancing Sharpe ratio from 0.45 to the 1.03 level.
• Rebalancing is key: However, when adding Bitcoin without rebalancing, overall risk suffers with 48.31% annualized volatility, almost four times higher than the benchmark of 13.51%. By comparison, the annual volatility of the S&P 500 sits around 20%. The most efficient rebalancing schedule is annual. This strategy has historically proven to be maximizing cumulative returns (313%) and the Sharpe (1.03) and Sortino (1.59) ratios.
• Timing doesn’t really matter: As investors argue that timing matters in crypto investments, the research showed regardless of when to add bitcoin to their portfolio, 75% of the time, the strategy outperformed the benchmark in the next 1 year, and 100% of the time, the strategy exceeded it in the next 3 years.

Figure 15: Portfolio with different rebalancing frequencies (5% BTC allocation)

Source: 21Shares

1% BTC allocation

We also tested six types of rebalancing strategies by adding just 1% constant bitcoin allocation to a simple growth portfolio (US Equity – 60%, US Bond – 40%): daily, weekly, monthly, quarterly, annually, and no rebalancing (see next slide). These are the key takeaways:

• Improved risk-adjusted returns: Adding crypto to an investor’s portfolio is noticeable with improved overall performance across all rebalance frequencies, improving annualized return and enhancing the Sharpe ratio from 0.45 to 0.63.
• Rebalancing is key: Surprisingly, adding just 1% constant bitcoin allocation also reduced annualized volatility across all rebalance frequencies, except no rebalancing, in which case overall risk suffers with 25.47% annualized volatility. The reduction in annualized volatility to bitcoin’s low correlation to equities and bonds.
• Timing doesn’t really matter: As investors argue that timing matters in crypto investments, the research showed regardless of when to add bitcoin to their portfolio, 75% of the time, the strategy outperformed the benchmark in the next 1 year, and 100% of the time, the strategy exceeded it in the next 3 years.

Figure 16: Portfolio with different rebalancing frequencies (1% BTC allocation)

Source: 21Shares

1% ETH allocation

We tested six types of rebalancing strategies by adding 1% constant ETH allocation to a simple growth portfolio (US Equity – 60%, US Bond – 40%): daily, weekly, monthly, quarterly, annually, and no rebalancing (see next slide). These are the key takeaways:

• Improved risk-adjusted returns: Adding ETH to an investor’s portfolio is noticeable with improved overall performance across all rebalance frequencies, improving annualized returns and enhancing the Sharpe ratio from 0.19 to 0.27.
• Rebalancing is key: However, when adding ETH without rebalancing, overall risk suffers with 24.16% annualized volatility, almost double the benchmark of 15.54%. By comparison, the annual volatility of the S&P 500 sits around 20%. The most efficient rebalancing schedule is quarterly. This strategy achieves the same volatility as the benchmark portfolio while improving the Sharpe (0.26) and Sortino (0.84) ratios.
• Timing doesn’t really matter: As investors argue that timing matters in crypto investments, the research showed regardless of when to add bitcoin to their portfolio, 70% of the time, the strategy outperformed the benchmark in the next 1 year, and 100% of the time, the strategy exceeded it in the next 3 years.

Figure 17: Portfolio with different rebalancing frequencies (1% ETH allocation)

Source: 21Shares

Conclusion

• Bitcoin valuation: We estimate the floor price of Bitcoin using the Mining Production Cost. In addition, we use relative valuation approaches like market sizing and multiples to value the asset (see Figure 18).
• Ethereum valuation: We value Ethereum using an intrinsic valuation computed with a discounted cash flow (DCF) method.
• Challenges relative to cryptoasset valuations: We aim to provide investors with the right tools to value this asset class, as there is no objective measure of value for cryptoassets today. However, it is worth remembering that the more uncomfortable an investor feels when valuing an asset, the greater the payoff of doing the valuation.
• Portfolio allocation: Adding Bitcoin and Ethereum to an investor’s portfolio may provide diversification benefits due to their low historical correlation to other asset classes. In our backtesting, it also improved overall performance across all rebalance frequencies, improving annualized returns and enhancing the Sharpe ratio.

Figure 18: Summary of valuation price ranges

Source: 21Shares