22 Dec 2022

A framework for evaluating token prices

The price of a token is determined by the equilibrium of demand and supply. For most tokens, the supply-side is known, and fluctuations in demand are the main price driver.
Note: To avoid confusion, think of demand as the combined willingness to hold or use a token at a given price, including the demand from current token holders.  We further believe that demand can be decomposed into Fundamental and Speculative demand. Speculative demand is typically erratic, unpredictable, and impossible to quantify. Fundamental demand, on the other hand, is typically slower moving, more persistent, and quantifiable. 
Fundamental value graph
Long term, fundamental demand will dominate and can be understood as a trend or driver around which speculative demand fluctuates. Hence, as a long-term investor, it is key to have a good understanding of the fundamental value drivers of an asset. Having a clear understanding of the fundamentals will both expose the relative size and direction of speculative demand and form the basis for developing long-term investment hypotheses and scenarios.To provide investors with a toolset to do exactly this, we are developing a framework for assessing the fundamental value of a cryptocurrency token. The framework is a work in progress and can be severely altered as we learn more. Currently, we are conceptually dividing the fundamentals of a token price into three main components; 
  • the store of value component
  • the medium of exchange component
  • the use of a token to access utility   
Three components
How we define the three components::1. The store of value component, or as we call it, the persistent financial premium. The best way to conceptually describe this category is by using physical gold as an example. Gold carries some intrinsic value due to its aesthetic appeal and scarce supply. Many things are, however, aesthetically appealing and scarce, without also having obtained the position as one of the prime global financial assets.Over time, and persistent throughout modern history, gold has been valued as more than an input into nice things. It has been used as an asset that maintains value across borders and time, despite political chaos. This property is not directly related to its intrinsic value, as an input into jewelry or other use cases. Hence, gold is persistently trading at a premium to its intrinsic value. This premium is the Store of Value component. 2. The medium of exchange function, or simply put, the money function. Money is a vital lubricant in the modern economy. To avoid inefficient bartering, money serves as a general means of exchange, or indirectly a much more efficient barter system. Instead of having to trade your labor directly for say  a pig, you receive some attestation that you now have the possibility of buying a pig’s worth of goods or services. Throughout modern economic history, money has been issued by the state, and its value relies on trusting the state enough. For a long time, trust was upheld by a promise that money could be converted to gold at a given rate. After the gold standard was abolished over 50 years ago, today’s money fully relies on trust in the monetary policy of the state. Money is complex and simple to evaluate at the same time. The velocity of money identity must hold true. How and why a certain velocity comes to fruition is though largely unexplained. 
QT of money
Still, the simple takeaway here is clear. Using a token as a general means of exchange will drive value to, or show the value of, a token, and there are frameworks to think about what this should mean for token prices. 3. Access utility - here, we are entering the landscape where more advanced blockchains should add value. Using bitcoin as an example, bitcoin’s value should lie almost solely in the two first components, store of value (1) and the money function (2). Ether, the native token of the more advanced Ethereum blockchain, can also hold value on 1 and 2, but the reason for its invention in the first place lies in the third component, use of Ether to access utility. Unlike 1 and 2, 3 can be clearly defined as an economic decision on the individual level. This allows for the development of models to predict how the use of a token to access utility will impact its value. While these models can provide valuable insights, it is important to note that the final token price will depend on the assumptions made about human behavior. Even so, we believe that the development of these models will allow for a more nuanced evaluation of token prices and how different scenarios may affect their value.Before rounding off, it’s worth mentioning that the three components are not necessarily fully independent of each other. Money is, for instance, a store of value, but most currencies do not have a financial premium in the sense we depict here. Still, you can argue that at least the US dollar has a persistent financial premium. Further, the financial premium might impact the use of a token as money and vice versa. The theoretical feedback loops can potentially be between all three categories here and is a topic we will revisit later. After reading this article, you are not much closer to an applicable framework for evaluating token prices. But rest assured, we are working hard on modeling the price impact from use in the three categories. We will share more of this work later. Even though the framework will never be as easy and understandable as the Discounted Cash Flow (DCF) model of stocks, the framework will help structure thinking about token prices and highlight that some token prices are just completely bananas. 
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