VALUATION OF DIGITAL ASSETS

Existing legacy asset valuation metrics are only partially applicable to digital assets. The present legal, accounting, technical, and back-office valuation infrastructure, along with the immaturity of the digital asset market, creates a climate of digital asset value ambiguity. Before evaluating new and growing digital asset valuation trends, this article analyzes existing asset valuation approaches and their limited applicability to digital assets.

The value of digital assets is unpredictable. Price volatility is common with digital assets, as well as liquidity issues that contribute to pricing mistakes. Established digital assets, like as Bitcoin, have been subject to pricing uncertainty from the market’s inception in 2009. The cost of has been constant since its start. Bitcoin has fluctuated dramatically and regularly depending on the market location.

Pricing deficiencies are at the forefront of the concerns threatening the digital asset market’s progress. The present legal, accounting, finance, technical, and back-office valuation infrastructure, along with the immaturity of the digital asset market, creates a situation in which digital asset value remains a mystery. Digital asset managers cannot be assured that they are appropriately evaluating their assets, and their investors may be dissatisfied with the managers’ efforts and technique. While many traditional assets cannot be properly valued, the lack of recognized price criteria for digital assets exacerbates the lack of valuation accuracy for financial reporting.

The traditional accounting terminology’s notion of fair value may not apply to digital assets. As a result, accurate value of digital assets for financial reporting purposes may be impossible. Digital assets may potentially fall outside of recognized accounting standards’ definitions of financial instruments. However, given the absence of parallel accounting language for digital assets, present practices call for the use of existing terms such as fair value.

Under current accounting language, it’s unclear how digital assets may be valued using fair valuation standards. In an orderly market, fair value is defined as the asset’s exit price at the time of sale. Three asset falls assist characterize fair value by reflecting the extent of judgment used in assessing fair values, from most liquid to least liquid. Assets in the Level 1 category are typically liquid exchange-traded assets with visible inputs. Bitcoin and Ethereum are the most liquid digital assets, thus they may be considered level one assets. Traditional dual-listed securities and Bitcoin and Ethereum have certain similarities. An asset will often be listed on numerous exchanges to increase market liquidity. When a securities gets duallisted in traditional markets, the bid-ask spread narrows because more liquidity is introduced into the market. This is in contrast to the crypto market, where the spread between the two exchanges may be as much as 5% during peak trading hours. This market arbitrage should continue to decrease as markets grow.

Level two assets are semi-liquid or illiquid, but asset managers can extrapolate pricing based on comparable assets. A quoted price for a similar asset or liability in an active market, or quoted prices for identical/similar assets or liabilities in non-active markets; i.e., markets where there are few transactions for the asset or liability, prices are not current, or price quotations vary over time or among market makers (some brokered markets), or markets where little information is released publicly (a principal-to-principal market).

From the reporting entity’s perspective, level three employs unobservable inputs that are generated internally. The most up-to-date information is used to analyze market participant assumptions. When there is little or no market activity for the asset or obligation at the measurement date, these inputs are employed.

Altcoins and security tokens may qualify for level two or three depending on their liquidity. For assets that do not qualify for level two, level three allows the adoption of customized pricing models. Because there are no closing prices on digital asset exchanges, digital asset managers cannot simply utilize the closing price for a specific asset.

The methods for valuing digital assets differ greatly. Due to tradeoffs between such techniques, digital asset managers have some valuation discretion. When quoting level securities, for example, some managers may use the price on their preferred bitcoin exchange, while others may combine prices from numerous markets. The lack of industry standards for digital asset valuation causes investors and managers to be hesitant and confused. Uniform standards for digital asset appraisal would be beneficial to the industry.

The development of digital assets as a valid financial asset necessitates their valuation. Digital currencies are being recognized as an emerging asset class, and an emerging derivatives market for digital currencies is progressively growing.

DIGITAL ASSET VALUATION

Digital Asset Valuation Issues in Practice

Digital asset value difficulties have resulted in litigation and are influencing business choices for digital asset firms. The current litigation record on digital asset valuation cases provides an early signal of digital asset valuation difficulties that may require additional elucidation.

Market Arbitrage Issues

Arbitrage is a widespread idea in traditional markets that has begun to sneak into the crypto markets. Individuals will traditionally try to arbitrage trade to cover the spread when stocks are purchased and sold for different prices at the same time. This has become one of the most important signs of a market that is inefficient.

Because of information asymmetries across multiple exchanges, arbitrage trading begins to take place. These disparities might arise as a consequence of incomplete disclosures or as a result of a company’s propensity to take on debt. As a result, market efficiency falls, potentially allowing arbitrage traders to profit from market circumstances.

On the South Korean exchange Bithumb, one of the most notable occurrences of arbitrage occurred. Coinbase was trading one bitcoin for around $18,500 on December 15, 2017, when Bitcoin reached its all-time high. Bithumb achieved $21,000 per Bitcoin on the same day. Traders who were able to time their deals right profited almost 14% simply by adding liquidity to the Bithumb market.

Because of the obstacles they would have to overcome before being able to use the US exchange Coinbase, it is improbable that any South Korean investor took advantage of this opportunity. Because Coinbase’s functional currency is the US dollar, the Korean investor would have had to convert his or her Korean Won into US dollars. This necessitates reliance on the foreign currency market, which would result in higher transaction fees. Furthermore, capital controls are enforced by South Korean regulators, making it impossible to shift substantial sums of money out of the nation.

South Korean officials must authorize every money transfer before it may leave the country. Crypto transactions have generally been banned by regulators because they do not comply with existing Korean financial or anti-money laundering legislation. Arbitrage traders may be supplying liquidity to markets that might otherwise be weak. On the other hand, if these markets were more open and had greater clarity on outstanding legal issues, there may be less arbitrage opportunity in the market.

Private Investment Fund Valuation Issues

Crypto valuation concerns have not been limited to exchanges; the private investment fund industry has also had difficulties. Polychain Capital, for example, was one of the first digital asset funds to be sued over the valuation of its digital assets. Mr. Greenhouse, a Polychain Capital investor who profited over 2000 percent on his investment, sued the fund in 2017 over the asset value.

Mr. Greenhouses’ decision to sue Polychain Capital was prompted by a series of incidents. Polychain Capital staff, according to Greenhouse, made inconsistent assertions about the worth of digital assets. Mr. Greenhouse had been informed by Polychain Capital that the fund’s most liquid assets would be appraised for redemption, and that a framework would be in place to value less liquid assets. Later, he was advised that the illiquid assets would be placed in side pockets and kept out of the redemption until Polychain Capital judged them liquid. Polychain concluded his redemption would be evaluated without the advantage of removing less liquid assets from the valuation procedure until their liquidity increased since Greenhouse sought complete withdrawal before Polychain had designated any side pockets. Polychain Capital advised Greenhouse that the fund’s asset valuation policy would not be made public upon request. Greenhouses’ requests for information and to halt his redemption were both refused by Polychain Capital. Mr. Greenhouse’s capital account with Polychain was redeemed, and he got a wire transfer for the withdrawal amount without any evidence or explanation of the valuation. Following that, the fund turned down demands to see its books and documents.

Greenhouse sued to assert his rights as a minority partner in Polychain Capital in 2018. Greenhouse had already withdrew from the partnership and completely redeemed his partnership stake when Greenhouse filed his complaint, therefore he was no longer a limited partner and so had no standing to check Polychain’s books and records. Greenhouse, according to Polychain, was only a creditor with no inspection powers. Greenhouse was not accused of resisting Polychain’s refusal to delay his departure from the partnership or of attempting to return the capital account payout after he got it, according to the lawsuit. As a result, the Court was unconvinced by Greenhouse’s oral arguments, concluding that these facts “do not change the fact that he has withdrawn from the partnership and no longer has rights as a limited partner.” As a result, the court determined that Greenhouse had no equity interest in the partnership and was not entitled to inspect the partnership’s books and records.

In short, the Court determined that only current limited partners have access to documents, and that limited partners who have left the partnership have rights and remedies as creditors of the partnership but no longer have an equity interest that would entitle them to limited partner rights. Greenhouse’s pro rata portion of extra assets that could not be valued when Greenhouse withdrew from the fund but could be valued as of January 30, 2019 was held to be accurate by the Court. Greenhouse did not get an ownership stake in Polychain Capital as part of the cash distribution.

Finally, it’s uncertain whether Polychain Capital would have won its lawsuit if Greenhouse hadn’t redeemed his position in the fund. Polychain Capital would have made the same disclosures and value arguments in either situation.

Digital Asset Characteristics’ Impact on Valuation

To guarantee a consistent positive value, digital assets are frequently programmed with hard caps—the exact maximum quantity of digital assets that may be distributed. To keep privately issued money issuers accountable for maintaining a consistently positive value, the “money” issuer makes a promise on either the price or the amount of “money” units that will be issued. The usual technique is issuing price commitments, also known as redemption contracts, and holding the issuer liable via an enforceable money-back guarantee. Such redemption contracts are untrustworthy. In contrast, cryptocurrencies’ pre-programmed smart contracts offer an enforceable and secure quantity pledge. A programmed enforceable quantity commitment, for example, assures that Bitcoin has a consistent positive value. The source code of cryptocurrencies is entirely transparent and continually verifiable on their separate blockchains.

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The consequences of supply constraints on digital assets are still being debated. Some claim that Bitcoin’s restricted supply and sluggish rate of expansion would lead to deflationary bias, which will eventually counteract the currency’s dropping value. Users may begin stockpiling as the value of cryptocurrency declines. If the supply is capped, it may not be possible to raise it to combat deflation or halt hoarding.

Others say that present digital currency quantity commitments will eventually lead to a bubble since the market price of digital assets is still subject to demand fluctuations and can only be related to speculative market value assumptions. In a similar vein, some academics argue that Bitcoin has no intrinsic value.38 In 2017, the cryptocurrency market grew due to a combination of improved ease of access, media attention, speculation, network mining activity, distrust of traditional banking, global instability hedging, and a demand effect from the market. In 2022, there is no consensus on a solid cryptocurrency value technique. Some academic valuation models focus on the labor aspect of cryptocurrency mining and might predict prices. Some valuation criteria are based on market price regressions against independent factors including gold market price, “bitcoin” occurrences in Google searches, and bitcoin velocity as assessed by transaction data. Other valuation models emphasize the relevance of include altcoins in Bitcoin valuation strategies or create a model based on Bitcoin’s cost of production.

TRADITIONAL ASSET VALUATION METRICS

Practitioners attempt to apply traditional asset valuation approaches whenever a new asset class enters the market. Although legacy valuation methods and concepts frequently fall short of finding the real fair value of a new asset class, they do provide a good beginning point for a new asset valuation research. As the digital asset area becomes more efficient, so should the accuracy of the digital asset valuation method.

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Fair value measures offer information about what an entity may obtain if it sold an asset or paid to transfer an obligation in an orderly transaction between market participants at the measurement date. The ASC 820 and IFRS 13 fair value standards give authoritative advice on fair value assessment, defining a framework that applies to all fair value measures under US GAAP and IFRS. These guidelines demand that fair value be assessed utilizing many important principles and an exit price (the price to sell an asset or transfer an obligation). The legal norm for valuation is fair market value, although it has flaws in practice.

Fair market appraisal is based on objectivity and observability. When inputs are less visible, more disclosure is required50 to explain the fair value of the entire asset or the main input(s) to the fair value determination. Observable inputs indicating unadjusted quoted prices for similar assets or liabilities in active markets are the highest priority level of inputs (referred to as “level 1” in valuation procedures). An active market is one in which the asset or obligation being measured sees enough volume and frequency of transactions to give pricing information on a regular basis. Other than listed prices, level two inputs are those that are immediately observable for the asset or liability. Unobservable level three inputs include a reporting entity’s or another entity’s own data.

Risk level should not be confused with observability. Although US Treasury securities are considered as risk-free, they are more correctly classified as level two since they do not trade on an active market.

Debt and equity investments, derivatives, financial assets/liabilities suitable for the fair value option, financial instruments, hybrid financial instruments, and stock compensation are all subject to ASC 820 methods. Financial instruments and revenue are valued using IFRS. These generalizations include exceptions in terms of scope and applicability.

Fair market value also relies on market participant assumptions, which are always changing.

Digital asset appraisals do not lend themselves well to traditional asset valuation procedures. Although stocks and cryptocurrencies are both traded on exchanges with fluctuating values and appear to be similar enough in context to support comparable regulation, they differ in terms of their potential for misuse, nature, acceptability, and usage. Any given valuation research is built on three main concepts: exit price, market price, and underlying worth of the asset if sold. When exit price is available, it limits the price that would be paid in a transaction of assets and liabilities between market players at the measured date.

When exit prices are unavailable but market prices are accessible, market prices are the exclusive foundation for valuing actively traded assets (quoted).

If the asset is an unquoted investment, a fair valuation implies that the underlying business or investment was sold at the measure date and then assigns the various interests properly (regardless of whether the underlying business is prepared for sale or whether the shareholders intend to sell in the near future).

The purpose of evaluating the value of a business in the event of an unquoted asset is to find the price that would be received to sell an asset or paid to transfer a liability in an ordinary transaction between market participants at a measurement date. The asset method, market approach, and discounted cash flow approach are the three most prevalent legacy approaches for determining this value. A firm is typically appraised using either a market method or discounted cash flow in a private market transaction. A study of each will give a starting point for understanding where we’ve come from and what changes might be required in the age of digital currencies.

The asset method values a company based on the fair market value of its underlying assets less its current obligations. In contrast to the market and DCF approaches, which adopt a returns-based strategy, the asset method analyzes future returns in excess of net assets, concentrating either on liquidation adjusted net assets.

The liquidation strategy addresses the scenario of a company discontinuing operations and liquidating its assets while also paying off all obligations. The valuation does not take into account any continuing business and simply considers asset disposition. It will only take into account expenditures linked with winding up the firm, such as asset sale commissions, debt prepayment penalties, employee severance fees, and taxes on disposals and dividends.

The book net asset value in the company accounts is the starting point for the adjusted net asset method. Because of the amount of depreciation done on the assets, book prices may not always represent fair value. A particular asset’s predicted useful life may differ from its actual useful life in practice. As a result, the adjusted net asset method tries to revalue the balance sheet values by bringing them closer to their current fair value. Bringing in equipment specialists to assess the depreciated replacement cost of the assets is one approach to do this. However, because intangible assets are not recorded on the balance sheet, the method fails to account for them.

When employing the asset strategy, keep in mind the requirement for specialists (machines value, debt, pensions, and so on), as well as off-balance-sheet assets and liabilities and tax implications (triggering capital gains). This method is beneficial for valuing financial services companies. The asset strategy can be used as a supplement to the returns-based approach described below.

The market method considers the enterprise value of peer firms, with the assumption that identical assets will sell for similar prices. The market method is based on three major assumptions: (1) the firm’s cash flow and earnings are comparable; (2) the company’s growth profile will remain consistent; and (3) the company will continue indefinitely. To properly apply the market value technique, the valuer must first comprehend the subject firm, then find peer company compatibilities, select the right multiple or sustainable basis, and then make modifications.

Understanding the firm being evaluated is the first stage in the market approach study. Analyzing business operations (type, scale of offering, and geographical diversification), historical and projected financial performance and position, quality and cyclicality of earnings (including seasonality), capital structure, and the industry and sector within which the company operates can all help to understand the asset’s growth potential and riskiness (future outlook and key developments). Peer firms should have similar growth and risk patterns to the valuation matter at hand. Important aspects to examine when considering a comparable sale include whether the deal is ongoing or concluded, if control was transferred, and the amount of synergies paid out.

Because it significantly evaluates other similar enterprises that have been sold, the market method is more subjective than the asset approach. When adopting the market technique, four elements are often considered: current investment prices, multiples, industry, valuation standards, and available market pricing.

When analyzing recent investments, one of the first questions to ask is whether the transactions were conducted at arm’s length. It is critical to understand the disposition of the parties before to a transaction if a firm plans to acquire another company through a transaction.

The Discounted Cash Flow (“DCF”) approach is commonly used to value future income, such as business cash flows (or, less frequently, to equity cash flows). Future revenue is less valuable to its receiver today than income that the recipient expects today. As a result, predicted net cash flows must be discounted in order to evaluate future income today. A discount rate is used to assess the present value of future projected net cash flows. The discount rate is a rate of return that takes into account the cash flows’ relative risk as well as the time value of money. The terminal value in a DCF analysis is the present value at the end of the projection period of all consecutive cash flows to the asset’s end of life, or in perpetuity. A DCF analysis forecasts future cash flows and terminal value, then discounts them to present value using the discount rate established. Capitalization, forecast assumptions, predicted profits or cash flows, and terminal value are all components in the DCF technique.

After debt payments and reinvestments for future growth, cash flows from assets move to equity, forming the cash flows accessible to all equity capital providers (“free cash flows”). The cost of raising equity funding is reflected in the discount rate.

When doing a DCF analysis in a currency other than the one utilized in the cash flow predictions, such as a digital asset vs USD or another fiat currency, the cash flows should be translated using either a foreign currency discount rate or a currency exchange forward curve. However, because digital assets are not traded on exchange markets where closing prices are easily available and reflective of fair value, there is no such predetermined discount rate or currency exchange forward curve available.

Principal-to-principal markets, in which transactions (originations and resales) are arranged directly and without the use of an intermediary, are the most analogous to digital asset exchanges. Because there is typically no publicly available information on principal-to-principal transactions, the markets are often not considered observable. If third-party pricing services are used, reporting entities must affirm that the prices were produced in conformity with the fair value standard.

For lack of marketability or liquidity, a pre-adjustment value should be discounted. Liquidity may have an indirect link with observability, but liquidity is not a distinguishing characteristic across input levels. A level two asset is a quotation for a non-liquid securities from a dealer who is ready and able to trade. Level 3 asset measures include complex instruments (currency swaps and structured derivatives with longer-term interest rates) as well as fixed income asset-backed securities.

The first stage in determining a company’s worth is to calculate its enterprise value using several valuation procedures. One of these strategies involves changing the enterprise value to account for aspects that a market participant would consider, such as excess assets or liabilities. The following is the equity value formula:

Equity Value = Enterprise Value – (debt – cash & investment)

Following the determination of the enterprise value, the money is allocated among the company’s relevant financial instruments, taking any priority into consideration. Further valuation methods may be utilized to focus in on the genuine valuation once you have a basic knowledge of what the firm is worth.

The discounted cash flow (“DCF”) technique forecasts a company’s unlevered free cash flow into the future and discounts it back to today’s Weighted Average Cost of Capital (“WACC”). Additional adjustments are done for lack of control, lack of marketability, liquidity, and various asset classes after the valuation is determined.

i. Lack of Liquidity

Traditionally, liquidity has been defined as the ease with which an asset may be changed into a country’s functional currency on demand. By transforming the asset into a functioning money, the individual has access to a wider range of products and services in the market. Because it is the most widely used means of exchange, a country’s functioning currency has long been regarded as the most liquid asset. Liquidity for any asset might alter over time based on the item’s market size.

Another notion under the idea of liquidity is market liquidity, which relates to the extent to which an individual has access to a market where assets may be purchased and sold at transparent prices. There must be a lot of trade volume in the market to have good market liquidity. In the past, if the difference between the bid and ask price grows too wide and trades are executed in significant quantities, the market would lose liquidity and the value of the asset will begin to plummet. As a result, when seeking to sell shares at that exact time, investors give up unrealized gains. It may be in an investor’s best advantage to keep the asset until the market becomes more liquid, allowing them to feely leave without being punished due to market circumstances.

In the private markets, a security’s lack of marketability can reduce its value and make leaving an investment difficult. A Discount for Lack of Marketability (“DLOM”) is usually applied by the market participant. The DLOM looks at whether a nonmarketable investment has a ready market, if an illiquid investment is frequently traded, and whether access to the market is restricted. A minority shareholding is often regarded as nonmarketable for investment reasons and must be discounted appropriately.

Marketability, or the legal ability to sell or transfer ownership of an asset, refers to its capability and simplicity of transfer. Liquidity refers to an asset holder’s capacity to quickly convert an asset into cash without losing a considerable amount of money. In conventional stocks, liquidity declines fast as trading volumes increase, resulting in widening bid-ask spreads, severe price impact, and frequent market failure. “A block of unregistered shares in a privately owned corporation suffers from a lack of both marketability and liquidity,” according to one source.

Several qualitative and qualitative elements are examined while developing an appropriate model to discount the investment. Historically, valuation models have taken into account the following:

  • Function of the restriction’s duration (time);
  • The investment’s inherent risk (volatility)
  • A possibility of liquidity in the future;
  • Potential buyer pool (the larger the pool of purchasers, the smaller the reduction);
  • Whether the commodity or service has a well-established market;
  • Future market growth potential
  • A restriction on the security’s transferability;
  • The number, scope, and conditions of contractual agreements that have been signed that influence the capacity to buy or sell securities;
  • The size and timing of any distributions to be made; and
  • Ownership concentration

The prospective put model, which focuses on loss avoidance; the Longstaff model, which focuses on unrealized profits; and the Quantitative Marketability Discount Model, which focuses on income, have all been developed throughout time to assess the discount amount owing to nonmarketable securities.

ii. Prospective Put Model (PPM)

A put option is a contract that allows you to sell financial assets at a certain price on or before a specific date. The premium is the option’s price, and it represents the present value of the risk-free rate, as well as the projected benefit of having the option at maturity. As a result, the capacity to exercise such a right leads to a loss of marketability, which must be taken into consideration.

A holder of an asset risks two types of price risk: 1) realized loss and 2) opportunity loss, which occurs when the asset’s price rises during illiquidity and then falls to a lower value before it can be liquidated. This risk is covered by a put option, and David Chaffe’s prospective put model, originally proposed in 1993, offers compensation for both sorts of losses. Chaffe developed a model to measures this discount by dividing the value of the put at the time period of restriction by the current value of the stock.

The discount for lack of marketability is calculated using the value of an at-the-money put with a life equal to the limitation divided by the marketable stock value in the prospective put model. This method generates prices that fluctuate inversely with interest rate and directly with time and volatility. The buyer is assured a price at least equal to today’s stock value by calculating the purchase at the time-money put option.

Price risk linked with a lack of liquidity is measured using put option models, in which the put option premium is utilized to assess the cost of liquidity. Put option models evaluate an owner’s price risk during a period of illiquidity. Market participants have long used this methodology to calculate the discount on nonmarketable securities. However, this method can be inaccurate because investors do not have perfect market-timing ability.

iii. Longstaff Model

A “look back” option allows the option to be exercised before it expires, allowing the holder to look back at the conclusion of the put option’s life and retrospectively execute the option at the highest stock price throughout the holding period, resulting in the largest return. Similarly, the Longstaff model focuses on restricted transferability and unrealized profits by considering the upper bound in the discount for lack of marketability via a hypothetical “look back” option.

Longstaff’s model assumes that an investor has ideal timing but is unable to execute the option to take advantage of it owing to a limitation period. Longstaff proposed that the value of marketability would be the present value of the additional cash flow received if the marketability constraint were loosened if an investor possessed perfect timing. Marketability would be less valuable to a real investor with poor market timing skills. Longstaff’s model therefore establishes an upper bound on the value of marketability, which serves as a standard for calculating the valuation implications of marketability constraints and indicates the highest discount for lack of marketability that could be maintained in a market with rational investors.

It has been proposed that this model is useful because it can determine if a nonmarketable instrument may be hedged and whether its owner has any competence in relation to the instrument (e.g. market timing ability). The basic assumptions of the Longstaff model are incongruous with reality, such as the estimated volatility level of ten to thirty percent, but tiny companies frequently have volatility exceeding fifty percent.

For establishing the lack of marketability at the shareholder level, the QMDM technique uses an income-based approach. In the early 1990s, Chris Mercer and Travis Harms created the QMDM to use the standard DCF model to evaluate illiquid stakes in closely held businesses during evaluations. Under the income approach to valuation, the QMDM is a shareholder-level discounted cash flow technique where value is a function of projected cash flow, risk, and growth. The concept raises worries about the security being retained for an extended length of time.

This model is based on the idea that investors in illiquid assets want higher rates of return than investors in liquid securities. In addition, the QMDM model requires that the appraisal was done at the marketable minority level of value.

The QMDM considers the rate of return information provided by restricted stock transactions over relevant holding periods to determine the applicable marketability discount, estimating the value of illiquid interests based on the expectation of benefits over relevant expected holding periods using appropriate discount rates to equate with present values. The following valuation inputs are considered by the model:

  • The predicted rate of increase in the value of the underlying business.
  • The anticipated dividend/distribution yield (expressed on a C-corporation equivalent basis)
  • The predicted rate of increase in dividends and distributions
  • The necessary rate of return during the holding term, or shareholders’ return rate of discount
  • The anticipated holding duration (or a range of holding periods).

One of the QMDM’s significant flaws is that it has never been adopted by a court in any case, despite being clearly stated in three tax cases from 2000, 2001, and 2006. The QMDM has also been chastised for requiring extra assumptions, calculating minority discount, and depending on arbitrary growth assumptions.

APPLICATION OF TRADITIONAL VALUATION METHODS TO DIGITAL ASSETS

Traditional valuation methodologies only apply to digital assets to a limited extent. While there are many similarities, the digital asset world necessitates a unique approach to digital asset pricing. Supply and demand, the number of competing digital assets, the cost of producing the asset through mining, rewards given to miners for verifying transactions on the blockchain, regulations governing sale and use, internal government, and news are all factors that influence the price of a digital asset.

 Market Pricing

Control exit or market prices when available. Bitcoin Charts publishes data on exit prices that may be used to determine average Bitcoin prices, but such a resource is not always accessible for other cryptocurrencies.

Traditionally, centralized exchanges have supplied liquidity in the digital asset market. Crypto exchanges, like regular exchanges, have a restricted number of users. They provide a market for a fee and assist with user account management. Trade execution on digital asset exchanges, on the other hand, is not the same as on traditional exchanges. The biggest problem might be that the number of token holders hasn’t increased exponentially year after year. With a larger number of investors, the market may have more liquidity, allowing for smoother movement in and out. Liquidity is one of the most important factors to consider when assessing the health of a market.

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Exchanges are the most frequent way to enter and leave the digital asset market today. Digital assets could previously only be exchanged on a centralized exchange (e.g., Coinbase, Binance, or Kraken), where custody and middleman concerns remained. Decentralized finance and decentralized exchanges first appeared in 2020. DEXes (decentralized exchanges) are smart contracts that let users to purchase, sell, and trade digital assets directly (peer-to-peer).

When people try to trade huge sums of digital assets at once, they become less liquid. If someone wishes to sell a large amount of tokens on an exchange, they must be careful not to flood the market with tokens, causing the exchange’s price to decline. Monitoring and buy-in are two remedies or treatments.

A government regulating authority or a self-regulatory entity monitoring the exchange to ensure compliance with current regulations might be one method for increasing trade volume. Many aspects of the legality of many crypto exchanges remain unclear, including the role of broker dealers and what constitutes a security under federal securities legislation. The market is being stifled by the uncertainties surrounding these legal problems. Increased liquidity in the market may follow after the market receives more clarification on the legal problems surrounding this new asset class.

Another strategy to enhance liquidity is to get the business community to buy in. Getting buy-in from the business community might entail employing crypto to conduct transactions. Increasing liquidity means being able to trade crypto for any item or service, not just fiat cash. Allowing transactions to be conducted using cryptocurrency may boost market liquidity.

Custody poses extra risks that are particular to digital asset exchanges. Traditional exchanges avoid the broker-dealer function and never handle the asset’s custody. Digital asset transactions, on the other hand, take place on the blockchain, requiring exchanges to hold funds in an offline digital wallet (traditionally referred to as cold storage). To facilitate decentralization, blockchain transactions must be kept indefinitely and redundantly on as many devices as feasible. By allowing the crypto exchange to serve as a regular broker/dealer and custody holder, digital asset exchanges incur risks and liabilities that traditional exchanges do not face.

As a result of these uncertainty, several exchanges have refused to accept any trading accounts from US residents. One difficulty with clients residing in the United States is the possibility of longarm legislation being used to the claim authority over them. When persons residing in the United States are barred from trading on digital asset exchanges, or when exchanges deny access to particular individuals based on residency or other factors, the number of players permitted in the market is reduced. When various exchanges have varying rules on who may trade on their platforms, the market sees different prices for the same item. This might be one of the reasons why arbitrage trading has grown so popular in the crypto market.

Private Market Transactions

Private market valuation is far less transparent than that of publicly traded corporations whose shares are acquired at a disclosed market price on a stock exchange. In a classic private market transaction, a firm is evaluated using either a market method or discounted cash flow.

a. Market Approach

The market approach evaluates a company’s enterprise value by looking at peer businesses’ cash flow and earnings, continuous growth profile, and indefinite continuation.

Technical core (blockchain native, ERC-20, Dapp, etc. ), token model (currency, stablecoin, utility, asset-backed, etc. ), underlying value (inherent, permission to use, permission to work, physical asset, share in enterprise), valuation trajectory (inflationary or deflationary), user experience, ecosystem breadth, consensus protocol, and governance are all factors that influence the adoption, success, and price of digital assets that are different from traditional assets.

The stablecoin was created to prevent price fluctuation in digital assets. A stablecoin is a cryptocurrency that is linked to the value of another asset (frequently fiat currency). A benefit of stablecoins has shown to be affordable, low friction international transfers. In fact, stablecoins are used to increase digital asset market liquidity by supplying stablecoins to DEX liquidity pools.

High-growth firms, like digital assets, require scenario planning since markets may not yet exist. Business executives must start from the future rather than the present in this situation.

The valuer can use secondary trade pricing or equivalent token prices when using the market method to digital assets. When liquidity is large enough to rely on these prices, secondary transaction pricing (as observed on exchanges) is relevant. Between token-to-token and token-to-fiat trading, the analysis for liquidity and depth of deals might differ dramatically. A valuer can discount for lack of liquidity as indicated above when liquidity is inadequate or uncertain. Tokens can also be evaluated using similar token values, with the variables suggesting comparability being the above-mentioned distinctive qualities of digital assets.

A handful of additional digital asset valuation models that were created in 2017 and 2018 may be useful in the future. First, network utility consumption valuation can capture a small portion of the value of utility tokens utilized as a pure means of trade for network access. Supply, demand, and velocity may all be used to derive the minimal network value. Second, the price-to-earnings ratio is comparable to the network value-to-transactions ratio.

b. Discounted Cash Flow

The Discounted Cash Flow model attempts to value the cash flows of a business. The discount rate takes into account the risk of future cash flows as well as the time value of money.

The Discounted Cash Flow model tries to value a company’s cash flows. The discount rate considers both the time value of money and the risk of future cash flows.

DCF is used in fee-incentivized networks, where platforms keep track of transaction fees and pay them out to token holders who undertake network labor. Some dispersed autonomous organizations employ this concept (DACs). Workers are paid service fees by PoW networks (Dash Master Nodes, Ethereum Validators after PoS) for the services they provide. Ripple, Stellar, Factcom, and Binance provide token burns or buybacks, similar to product sales paid for with company stock or treasury shares (share repurchases). Tokens are bought and destroyed in this situation for usage on the network or to disperse earnings. Next, networks pay newly-minted block rewards to workers as an expenditure that redistributes value (Stellar, Factcom Federated Servers, Dash, Pivx). These are dividend payments, in which token holders get a steady stream of value.

The inflationary or deflationary model of a token has an influence on cash flow. A deflationary approach of token issuance limits the quantity of tokens that a given token issuer may ever issue. Tokens like Bitcoin make use of this mechanism. Prices are predicted to rise in a deflationary fashion owing to the underlying limitation of token supply.

Tokens that use an inflationary model frequently try to mimic the behavior of fiat currency. This usually signifies that there is no limit on the amount of tokens that may be issued. Inflationary token models, on the other hand, take into account a continuous token minting process that gives the issuer additional flexibility based on the current condition of the token and the overall market environment. Several indicators point to inflationary token structures becoming increasingly prevalent as the cryptocurrency industry matures. Inflationary token models enable for the usage of stability methods, allowing for additional volatility mitigation experiments.

The reward per mined transaction in Bitcoin has declined over time from its original value of 50 BTC in 2009. The reward per mined transaction was 6.25 bitcoins in November 2021.

A trailing twelve-month revenue to miners, stakers, and liquidity providers is one valuation method that focuses on cash inflow.145 Another is a stock-toflow model, which shows that the price of BTC has historically correlated inversely to mining reward amount.146 However, BTC’s issuance schedule and relative scarcity are not the only reasons for its rise in value. “Thousands of bitcoin knockoffs exist, all with the same issue schedules, but none can match bitcoin’s demand and consequently its value.”

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Traditional valuation methodologies only apply to digital assets to a limited extent. While there are many similarities, the digital asset world necessitates a unique approach to digital asset pricing. The methods for valuing digital assets differ greatly. Due to tradeoffs between such techniques, digital asset managers have some valuation discretion. The lack of industry standards for digital asset valuation causes investors and managers to be hesitant and confused. The sector would benefit from standardized digital asset value standards. Standards like this might change over time as the market changes. Setting standards necessitates the adoption of shared basic practices that are continually changing.

To gain more insights about valuing digital assets, feel free to consult with a Credo advisor!

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