How to Make It in Crypto — Full Diluted Valuations
Don’t be the sheep that gets slaughtered by inflated valuations
On “Making It”
A lot of you that are new to crypto are probably wondering how you “make it.” Often the mental construct is to hopefully buy coin when price low and sell coin when price high. Yes, that’s the core strategy of any investment thesis but not really helpful since it’s not a framework you can apply a logic tree to and derive a probabilistic answer from.
This framework isn’t to achieve mediocre returns. This is for exceptional returns that make you stand out from the pack.
In this piece, I want to explain to you the most important mental construct that underpins being an investor in any market — valuations. More specifically:
Fully diluted valuations (FDV) refer to the total number of tokens ever multiplied by the current price of a single token.
Market cap (MC) refers to the number of tokens that are available RIGHT NOW in the market multiplied by the price of a single token. We will ignore this for now.
A really simple way of understanding fully diluted valuations (FDVs) is what percentage of the network do you actually own? This is especially important when an asset produces cash flows.
Let’s take a simple example below:
You have 100 tokens in total
Each token is worth $1
$100 in cash flows is distributed to holders
Each token has now received $1 in yield netting a 100% ROI
The price of each token increases to $10
The same $100 cash flow now only nets 10% ROI if you purchased the asset
Essentially what I’m highlighting is your ownership percentage is critical for determining the price you pay for current & future cash flows.
Highest Theoretical Valuation
When you’re investing in a token you want to understand what is the highest valuation this token could reach today relative to what’s on the market. Most valuations are relative in nature. To make this really simple, let’s say you’re launching a new DEX.
The new DEX has a fully diluted valuation of $10m and a market cap of $5m
Now, what we want to do is some simple market research and look at the stats for other DEXs. So we do our research and come back with the following results:
Uniswap has an FDV of $5.1B and MC of $2.3B
Curve has an FDV of $4B and MC of $467M
Balancer has an FDV of $1.9B and MC of $73M
So roughly what we learned from the market is that the price of being the best DEX today (we’ll come back to the word today later) is roughly $4-5B. So, we could say that our new theoretical DEX has about 500x upside in it ($5B divided by $10M).
”Great, I’ve found my gem!”
What Needs to be True
Not so fast. Unfortunately, in our example above. While it could have an upside of 500x our capital. There are a few problems. We’re making a huge assumption:
This new DEX will be as successful as Uniswap/Curve!
That’s quite the assumption to make. But let’s run with it for a minute. What would need to be true in order for that statement to be valid:
The team would need to pioneer a novel new AMM formula (Uniswap pioneered the constant product formula, Curve pioneered the constant function formula)
The product would need to be differentiated and offer something users want but can’t get with existing market products
The execution of this game plan is flawless (product is built, team works well, marketing is on point, gets community love, has deep composability)
Those are three enormous truths that would need to be true. Now here’s where it gets a bit wonky. If a DEX like this existed today, the price of it would get bid up to $50m-$100m before it even launched. If this was to occur your upside as an investor has evaporated from 500x to 50x. That isn’t terrible but you’re now expressing the probability of success from:
0.2% (1/500) to 2% (1/50)
What would be even crazier is if this token launched at a $1b FDV without any traction or product. Suddenly you’re expecting a 20% probability of success without gathering ANY evidence that the assumptions made in your investment have been derisked. The numerical probability of success should at least bear some semblance of the qualitative traction to date. Anything that hasn’t launched and is worth billions is propped by a lot of delusional money.
It’s absolutely ludicrous that professional capital allocators are willing to make such miscalculated decisions. However most of the time they have different incentive structures so they don’t really care and will make suboptimal trade-offs for their LPs (if you’re an LP you’re probably getting rekt by your crypto money manager’s misaligned incentives btw).
Hopefully you can see there is a very clear relationship here between the price you pay for an asset and what needs to be true for that asset to grow into the valuation it commands on the market (today and in the future).
Future Market Growth
Now here’s the wild card that you can’t really predict but do need to factor into your investment equation.
How big do you expect the market to grow in the future and will this company grow with the future of the market or stay stagnant?
Let’s use our example of the DEX.
We know that the price of the best DEX is about $4b-$5b in today’s market conditions.
We know that the total amount of TVL locked in DeFi right now is about $50b-$100b
We know that TradFi is a deca-trillion market (tens of trillions of dollars)
We can therefore with a high degree of certainty say that DeFi over the next decade will experience growth anywhere between 10x-1000x what it is today.
This assumption holds true because we empirically know that DeFi is 10x better than existing banking tools (instant settlement, global from day 1, no paperwork)
Okay so now that we’ve gathered our truths and bounded the range of possibilities, we can start to reason about our new DEX in a more intelligent way.
We know that a DEX in the future is going to be worth a DEX today. However, the future is going to look very different with new technologies and structural landscape changes. Because we can’t predict the future (and we shouldn’t make any assumptions about it), the only thing we do want to see is:
How adaptable is the team relative to new information that impacts their core strategy?
If the team doesn’t update their strategy in light of new information or isn’t actively conscious of the trade offs they make, we have a problem: they may not be able to grow to the valuation of a DEX in the future and be undercut by new competitors. This simultaneously gives rise to investment opportunities in new markets where the upside isn’t known yet. This is where you research and your informed viewpoint comes in.
As you can hopefully tell, the price you pay for an asset is the difference between being a mega winner and making a bit of money on the side. Be critical of the price you pay for an asset and the assumptions that come along with paying that price tag. Also having an informed, well-researched view of new markets is just as critical.
If you’re interested in learning more about then I’d highly recommend you read “The Most Important Thing” by Howard Marks. This book has been the single most impactful book in my mental framework for investing.