Basics: Value and speculation

The basics of price, part 3

This is part three of a three-part series on price. Part one can be found here, and part two can be found here.

In part one of our series on price, we discussed how buyers and sellers agree upon a price for an asset on an order-book-based exchange. In part two, we zoomed out and looked at how supply and demand determine what prices buyers and sellers might choose. In this final segment, we’ll zoom out once again and look at what causes demand.

Intrinsic Value

The intrinsic value of an asset is what the asset is really worth. This can differ significantly from the price of an asset.

Part of why price differs from intrinsic value is that intrinsic value is very difficult to pin down accurately. There are a lot of factors that cause an asset to have intrinsic value. A big part of the mission of this blog is to give people the tools to better assess the intrinsic value of investments in cryptocurrencies.

A key aspect of value is that goods or services have value because people want or need them for their own properties, not because they can be sold for a profit. Houses have value because people need places to lives. Food has value because people need to eat. Plumbing services have value because people need their toilets to stop overflowing.

There’s nuance here. Obviously, there is profit to be made in reselling houses and food, and there’s probably even a profit to be made in subcontracting plumbing. But ultimately, reselling houses and food wouldn’t be a profitable business if there weren’t people who wanted to live in the houses and people who wanted to eat the food.

Where this becomes nuanced is that the ability to create value, is itself valuable. A commuter car is a good example of this: the car goes down in value over time, so the commuter can’t reasonably expect to make money off reselling the car. However, the commuter drives the car to work each day and (hopefully) makes more money by working than they spent on the car. The commuter car has intrinsic value because it allows the commuter to make money at work.

A final thing of note: things have intrinsic value if they have value to someone, but in most cases, even very valuable things don’t have value to everyone. I personally have no use for makeup, but my girlfriend loves it (makeup has value).

Layers of abstraction

You can’t eat a stock or live in it, so what gives a stock intrinsic value?

Let’s start with companies.

Remember that the ability to create value, is itself valuable. We’ve talked about how houses and food and cars are valuable. How do we go about creating those things?

Well to build a house or grow food you need land (land is valuable). Technically you probably also need land to build cars, but you also need factories full of manufacturing machinery (factories full of manufacturing machinery are valuable). And you need raw materials to build the house and the car (raw materials are valuable).

But the land and the raw materials and factories are all just sitting there if you don’t have workers, and you have to organize them based on skill to do the different tasks involved in building the house or car or planting and tending crops. This organizational structure takes a lot of work to create, and it’s what enables you to assemble the raw materials and plant the crops to create value, so this organizational structure of workers has value.

And all of that stuff together is a company, which is able to create value. Companies which are able to assemble all the necessary ingredients to create value, have value.

Owning a share of stock in a company, means you own a fraction of that company. Stock has value.

Companies have a legal obligation to provide value to shareholders. There are a few ways companies can do this, but in the simplest case, the company distributes the value to shareholders in the form of dividends.¹ This is why stocks which pay strong dividends are called value stocks. People who invest in these kinds of stocks are called value investors.

But there is another way to make money off stocks.

Speculation

What if, instead of looking at the value of a stock, and trying to find stocks that would pay good dividends, we tried to find stocks that would have value in the future? In that case, the value now wouldn’t be as important, because our main way of making money would be to sell the stock at a later date when it’s worth more. This is called speculation.

What if, we didn’t look at value at all, even future value, and instead looked at what speculators are doing and try to buy it before the price goes up due to speculation? That’s… also called speculation.

You can go pretty deep with all the forms of speculation, but the idea here is that if you’re buying because you think the price will change and you’ll be able to sell for more at a later date, you’re speculating.

Some companies are committed to increasing their value, which makes their stocks suitable for buying low so you can sell them high. The way they commit to growth is, instead of distributing their profits to shareholders in the form of dividends, they reinvest those profits into increasing the size of the company. Stocks of companies that do this are known as growth stocks, and investors who like these kinds of stocks are called growth investors.

Remember that the company has a legal obligation to provide value to shareholders. If the shareholders are unhappy with the company not distributing dividends, they could take a shareholder vote, or sue, and force the company to pay a dividend. But usually growth investors are happy to see the value of their shares go up.

There are a lot of ways that value versus speculation isn’t a clear binary. An investor might think a new CEO is smart. A smart new CEO arguably increases the company’s ability to create value (a smart CEO is valuable) but a smart CEO might also grow the company (we might speculate that the share price will grow).

Ultimately, if a company doesn’t grow its value, it is unlikely to grow in price, so growth investors can’t entirely ignore value.

This is no nonsense crypto, not no nonsense stocks

One of the big mistakes people make when investing in cryptocurrency is to believe that we can just throw away all the economic principles from the stock market that people have studied for decades, because cryptocurrencies are different.

It’s true that there are some difference, but largely, the underlying market forces are the same. And many of the differences are actually problems, which were solved in the stock market, but which cryptocurrency has yet to solve.

For example: unlike a companies legal obligations to shareholders, in most cases cryptocurrency projects have no established legal obligation to coin holders.² This is a huge problem: there are many very successful DeFi platforms which bring in lots of profits, but simply haven’t found a way to distribute those profits to their coin holders.³

Just as with stocks, demand for the stock can come from value or speculation.

You’ll notice above, that I didn’t really have to explain the value of a house or a car. But once we added a few layers of abstraction, it took a whole section of writing to explain the value of a stock. Cryptocurrencies are an abstractionist’s playground that adds much more abstraction, and it can be much, much more complicated to explain why a cryptocurrency is valuable, and it may be difficult to see if a cryptocurrency isn’t valuable. A lot of this blog’s future articles will be spent analyzing specific coins and projects, and trying to understand whether they do or don’t have value.

The basis of a coin or project’s value is called its value proposition. Without going into too many specifics or more difficult examples⁴, the rest of this article will outline some principles for finding the value propositions of projects.

Who is putting money in that they don’t expect to get back? And what good or service are they receiving in exchange?

The simplest way to find value is to look at who is putting money into the system that they don’t expect to get back. Typically, the reason someone puts money into a system without expecting to get it back, is that they are receiving some good or service in return. Often, in cryptocurrency, this is some sort of fee. Some examples:

When people pay gas fees on the Ethereum chain, they don’t expect to get those fees back. They’re a total loss. The reason they pay those fees is because it allows them to execute programs, on the Ethereum blockchain. Since these fees can only be paid in Ethereum, people need/want Ethereum to pay those fees. That’s Ethereum’s value proposition. Most (all?) gas tokens have a similar value proposition.

What problem do people have that this solves?

Another common value proposition for cryptocurrency projects is that they solve some problem.

If you deposit your WETH onto Aave on the Polygon network, you’ll receive an equal amount of amWETH, which you can exchange back for WETH at any time. You’ll receive interest on your deposit by the amount of amWETH going up, and you’ll also receive interest as MATIC which you can withdraw from the protocol.

This can be annoying because then to track your investment, you have to track the price of two coins. Additionally, the MATIC isn’t automatically reinvested, so once you receive the MATIC, you’re not receiving interest on the MATIC. You can manually exchange your MATIC for WETH, and then deposit the WETH, but it’s annoying to do by hand, and you’ll be paying gas fees every time you do it.

Beefy Finance solves this. Once you deposit your WETH and receive your amWETH, you deposit your amWETH into Beefy’s amWETH vault and Beefy begins collecting the MATIC for you, and trading it in so you receive more amWETH instead. It does this at an optimal rate to make sure you’re maximizing income without paying too many gas fees. And since the fees are split between you and everyone else in the vault, you pay even less in fees. This solves the problem of manually compounding.

You do pay a fee to Beefy for this service, but it’s well worth it in my opinion. There are other autocompounders which work similarly. Beefy solves a problem that I have, so I know the platform has value—it has value to me!

Circular value, isn’t value

A common trick that cryptocurrency projects use to get people to buy their coin, is that you can temporarily deposit the coin into a contract⁵, and in exchange they’ll pay you more of the coin.

This isn’t a value proposition. Remember, we did say that the ability to create value, is itself valuable. But simply minting new coins and giving them to people who deposit the coin isn’t creating value. The coin purports to have value because you can use it to get more value, but the value you’re getting is just the ability to get more of the coin.

What drives up the price of such coins isn’t value, it’s speculation. I’ll cover this more in depth in a later article, but for now, let’s just say, it is well-known that this pattern doesn’t work, and projects who create coins like this, can’t reasonably plead ignorance. This is a scam.

That’s a heavy accusation, so I want to be very clear about who I’m accusing here. I’m accusing projects where the only value proposition of the coin is the ability to deposit coins to receive more of the coin. Notice the word “only”.

If you’re familiar with the Beefy project I discussed in the previous section, you’ll know that Beefy has a coin, BIFI, which can be deposited in a contract they call “BIFI Maxi” in exchange for receiving more BIFI coin.

However, this doesn’t fit the scam description I wrote above, because the ability to deposit the BIFI coin and receive more BIFI coin isn’t the only thing giving the BIFI coin value. The BIFI coins aren’t just being minted, they’re being purchased from exchanges using profits from the BIFI platform. This takes the value created by the Beefy platform, and converts it into value for the BIFI coin. This isn’t a scam, it’s a way of distributing profits to coin holders.

There are a few reasons why I don’t like this profit sharing mechanism: I’m not personally invested in BIFI⁶. One of the reasons I don’t like it, is that it looks like a scam. But, it isn’t a scam. There are numerous legitimate projects that use this profit sharing mechanism (SushiSwap, QuickSwap, and Dfyn are more examples).

Exercises

Use the following exercises to test your understanding.

In the last few weeks we’ve zoomed out from the specifics of price to a bird’s-eye view, and as such it’s harder to come up with objective answers to questions. Unlike previous weeks, I’m not going to provide answers to these exercises.

Instead, the purpose of these exercises is to get you started on thinking about applying the topics we’ve discussed to forming your own opinions. You may need to do some research—there’s no way around this. Understanding the intrinsic value of assets is complicated, difficult work! But if you build the skill of finding intrinsic value, it will pay off.

1. We briefly mentioned in this article that platforms such as Aave or Cream, allow users to deposit assets into their contracts. Other users can borrow these assets, and pay an interest rate while they are borrowing the assets. The users who deposited assets into the contracts receive an interest rate on their deposits. Who is putting in money that they don’t expect to receive back? And what do they receive in exchange?

2. Aave and Cream also have coins. Do some research on these coins. What is the value proposition of these coins?

3. I have USDC on the Polygon blockchain, and I want to exchange it for LINK. Are there any cryptocurrency projects that solve this problem for me? How do I pay for this service?

4. I have USDC on the Polygon blockchain, and I want to move my USDC onto the Avalanche blockchain. Are there any cryptocurrency projects that solve this problem for me? How do I pay for this service?

5. On May 8, 2021, Elon Musk appeared on the show Saturday Night Live, and made a few jokes about DogeCoin. In one joke he referred to DogeCoin as “a hustle”. By the next day, the price of DogeCoin had fallen 40%. The supply of DogeCoin remained fairly consistent during this short period, so we know this was a change in demand. Do you think that DogeCoin lost demand because it lost intrinsic value, or because it lost speculation?

6. On January 14, 2022, Elon Musk Tweeted that Tesla would accept DogeCoin as payment for some Tesla merchandise. DogeCoin rose 11%. Do you think that DogeCoin gained demand because it gained intrinsic value, or because it gained speculation?

1. I’ve skimmed over a detail here. A company creates value, and then typically exchanges it for a more fungible form of value: fiat currency. This is usually what’s paid out in dividends. The reasons that fiat currency has value are complicated—for now let’s just agree that workers and shareholders in a car manufacturer probably don’t want their salaries and dividends paid out in partial cars, so it’s necessary to exchange the value into a form where people can go exchange it for whatever value they want or need.

2. This is a big problem for the idea of governance tokens, which I’ll go over in a future article.

3. It’s worth questioning the idea that projects should even release a token, given simply holding a token contributes nothing to a project. This will be discussed in a future article.

4. Readers may be frustrated that I’m not covering the value propositions (or lacks thereof) of popular projects like lending platforms, AMMs or rebase protocols. Please be patient, these protocols are more complicated and need to be in their own articles to be fully explained.

5. I’m not using the word “stake” here, because that term has too many different meanings in different cryptocurrency contexts.

6. Perhaps instead of “Cryptocurrency information without the hype”, the subtitle of this blog should be, “this will be discussed in a future article”.