For those of us overwhelmed with the hype and news around bitcoin, cryptocurrencies and initial coin offerings – where should we start, if at all, in this space?
A useful first step might be to go back a hundred or so years and think about the fundamentals of value.
If we were looking to invest in a company that did something – make tyres for example – we might look at the amount of money it throws off as profit every year.
Then the total value of the company is the sum of all that money over its lifetime, lets say 20 years to be conservative.
In that case, we should be willing to pay a percentage of that total (a discount) today in order to get that return over time.
And that, essentially, is the way businesses are valued in stock markets.
Currencies, on the other hand, are thought of as a way to exchange value. Instead of exchanging my rice for your beans, we exchange notes instead.
But really, a currency is a form of IOU – it represents a debt.
If you look at a £10 note from the Bank of England, it has the words I promise to pay the bearer on demand the sum of ten pounds.
This comes from the days when the pound was pegged to gold – if we took ten pounds to the bank, they would be required to give us its value in gold.
That doesn’t happen any more – the value that £10 now has is created by our belief in its value.
And what we believe is that the £10 will buy us something – a meal, a football, a cinema ticket.
So, what is important in a currency is that we are willing to give it away. We exchange it for something that we believe has the amount of value represented by the money we have.
A fundamental requirement for a currency, then, is that we are willing to use it as a medium of exchange.
If the value of the currency itself becomes too high relative to other thing we value, like bitcoin has in relation to the US dollar, then we are likely to hoard it.
This sounds like hyperinflation and has happened before. In 2008, one US dollar was worth $2,621,984,228 when converted to the Zimbabwe dollar.
The Zimbabwe dollar, unsurprisingly, no longer exists.
So, what’s the difference between a cryptocurrency coin and an initial coin offering (ICO)?
An ICO is a way to raise cryptocurrency money for a new business.
Instead of raising dollars like an Initial Public Offering (IPO), an ICO can create new currencies or raise funds in existing cryptocurrencies or even standard currencies.
The general idea is that the value of tokens exchanged for currency in an ICO represents a share of the value of the business.
Investors can gain from a rise in the value of the tokens as the underlying business grows.
Or lose everything…
This, however, sounds very similar to the way in which existing markets work.
The fundamental value of a token issued by a business will depend on the cashflows expected to be generated by the business.
In very early stage businesses, these may be almost impossible to predict. We may invest purely on the strength of the founding team, their experience and previous record of success.
As we understand the business more and where it makes its money, we may be able to make a more rational assessment of value.
At that point, the market price of the tokens can be compared to what we think intrinsic value might be, allowing long term investors to take a position.
The fundamental principle of investing is that the amount of money we give today should have a relationship to the amount of money we expect to be returned by the business over time.
That’s where value comes from.
Putting money into the market hoping to catch a wave – like housing markets in the mid 2000s or dot coms in 1999 – is betting on valuations and is essentially speculation and gambling.
Some people may get very rich…
But for the rest of us, the first step to valuing an ICO is to do the basics – look at the underlying company, the management team, the proposition and the expected cashflows and come up with a number that represents the value of the business.
Then, see how much of a premium over value we will have pay for a token in that business in order to make an investment decision.