I’m quite frankly tired of hearing people rave about cryptocurrency. You’re not going to get rich off this crap. Chances are you’re going to lose most of the money you put into it. Because it’s overvalued, overhyped vaporware. And in this article I will prove it.
This isn’t a post out of jealousy or anything. I’m genuinely happy for the people that got lucky, made life changing money from this stuff, and cashed out. But also sad and frustrated at the same time, because the gains of those who cashed out are financed by the suckers buying in today who think the performance of the early buyers will repeat for themselves. A poll by cryptocurrency exchange Huobi of over 3,000 people discovered that 68% had only begun buying cryptocurrencies in 2021. Now what does that remind you of…?
As I wrote in my last article on the “Everything Bubble,” 31% of U.S. adults (including 46% of millennials and 59% of Gen Z) believe that they will become millionaires off of their cryptocurrency investments, according to a survey by Engine Insights. That’s over half of adults age 40 and under. In the context of that statistic, it sounds utterly ridiculous when people buying in today try to claim that they’re early adopters.
Remember economist Robert Shiller’s definition of asset bubbles and how they “spread by psychological contagion from person to person”? Well, what happens to viruses when they’ve already infected the majority of people? Fires when they run out of oxygen or fuel to consume? They burn themselves out.
A similar phenomenon occurs with asset bubbles. Massively overvalued assets (low or no intrinsic value relative to very high prices) exist in a fragile state, for no rational investor would buy for example, stock in a company with a market capitalization of 2,000 times its annual earnings. Markets love mean reversion. At some point the collective mass delusion will be lifted by an external event, or it will continue until it can no longer spread fast enough to engulf enough money to continue fighting reality, and burn itself out.
Cryptocurrency may have already reached the point of burnout, or it may have another leg up if enough people can convince their grandma to buy their digital ledger entry for more than they paid for it. But one thing is blatantly clear, and it’s that the 31% of surveyed U.S. adults who think they’re going to become millionaires off this crap are running out of greater fools to convince.
Of course, a number of people believing they’ll profit off of something doesn’t necessarily mean that they’re wrong: the majority of stock market investors make a profit. However, the stock market over the long-term is a positive-sum game — real companies backed by real assets, with real earnings are deploying capital and resources to produce more value over time. This effect compounding over years and decades creates many millionaires.
So I’m not going to attack crypto only from a philosophical standpoint in this article. We’re going to give it the benefit of the doubt, and assume that it’s not a zero or negative-sum game, but that it does have the potential to create value. Instead, we will prove that it is so laughably overvalued and overhyped as to be fundamentally equivalent to an asset with zero intrinsic value. This distinction is nuanced but important to fend off detractors who may want to lump this article in with the attacks from many of the cryptocurrency critics who are not educated on the space.
But enough words for now, I said I’d prove that this stuff was overvalued. So let’s start setting up some numbers.
A simple valuation model for Proof of Stake (PoS) cryptocurrencies
Most everyone who has heard of cryptocurrency has heard of mining. I’ve mined at home myself using my GPU. This is the Proof of Work (PoW) model, wherein participants contribute their computing power to securing the network and validating transactions. Miners are rewarded with cryptocurrency tokens when they successfully solve a cryptographic problem and mint a block to add to the blockchain.
Many of the new and rising cryptocurrencies today use a Proof of Stake (PoS) consensus mechanism, and some existing PoW coins like Ethereum are planning on making the shift to PoS in the future. In this model, transaction validators stake their tokens as collateral. Malicious behavior is discouraged, since bad actors will have their tokens confiscated. In return for their participation in the network, validators receive:
- A proportion of new tokens created as part of a network’s built-in inflation mechanism.
- A commensurate portion of network fees generated by users transacting on the network.
The first one is to encourage holders to participate in the network. Those who don’t, will effectively have their tokens “diluted” over time. Likewise, if every single user staked their tokens, each users’ buying power would remain the same relative to each other. Obviously the staking percentage will not be 100%, since then there would be no tokens remaining to transact on the network. It’s also not zero percent for obvious reasons, and probably also not a very low percentage as a minority of participants capturing, for example, a 3% token supply inflation would be a massive return and thus encourage other participants to stake.
Token inflation is similar enough to money creation and inflation of fiat currency that we’re going to ignore the specifics here (as they vary by network and change over time) to focus on the real measure of network usage — and thus value — exemplified by our second factor.
Users on cryptocurrency networks pay a fee when they send transactions, or initialize or interact with smart contracts and decentralized apps. The sum of this over time could be described as the “earnings” of the network which will be distributed to network validators.
A simple valuation model for PoS cryptocurrencies then would look very similar to the Price-to-Earnings (P/E) ratio that’s used in the stock market, which is:
Adapting our model to fit the PoS cryptocurrency framework, we end up with the following:
Each token therefore represents a potential claim of ownership on a fractional share of a cryptocurrency network’s earnings distributed among network validators. Just as a share of stock represents a claim on the assets and earnings of a corporation distributed among shareholders. Cryptocurrency investors who do not understand this relationship do not have much comprehension of what they are actually investing in when they purchase tokens in a Proof of Stake network.
Applying our model: Cardano (ADA)
Let’s evaluate Cardano (ADA), the 5th most valuable cryptocurrency by market capitalization. Cardano describes itself as “a decentralized third-generation proof-of-stake blockchain platform and home to the ADA cryptocurrency. It is the first blockchain platform to evolve out of a scientific philosophy and a research-first driven approach.”
Market capitalization is easy enough to find on many sites. We see above that this project has a market cap of $48.845 billion.
I found some data on messari.io which provides the total daily transaction fees and revenue for the Cardano blockchain, then verified it with a couple other sources. I downloaded the data for the past year and summed it. The result is $8.605 million in fees and revenue.
Thanks to Staking Rewards, we’ve got our final variable, the percentage of Cardano tokens staked:
Now we can just plug in the variables into our valuation model:
The complete and utter absurdity of this number should be obvious to anybody that’s spent a bit of time examining basic stock market metrics. For some context, the P/E of the S&P 500 is currently 25.85. This is considered high by historical averages. In other words, to purchase $1 of trailing 12 month earnings in a market cap weighted fund of the 500 largest publicly traded companies in America, it will cost you $25.85. To purchase $1 of trailing 12 month earnings in the Cardano network, it will cost you $3,931.
So for Cardano to reach a similar relative valuation to the S&P 500, the price must stay constant while the network sees activity and fees increase by over 15,000%. Except, uh oh, the network is already nearly at maximum capacity:
So is Cardano worth $1.52 per token? No, it’s worth more like a penny per token, and in all honesty probably zero, because nothing of any real value to the world occurs on the Cardano blockchain (or on most blockchains, for that matter). Most activity is just a further layer of speculation, such as users purchasing NFTs that they hope will increase in price, or using a decentralized exchange like SundaeSwap to trade for other cryptocurrency tokens that they hope will increase in price. Once the speculative fervor surrounding cryptocurrency evaporates, so too will the majority of Cardano’s network revenue.
In conclusion, Cardano’s P/E ratio of 3,931 represents a speculative bubble of utterly massive proportions. Investors in this token should expect to lose all or most of the money they’ve put into it.
Applying our model: Algorand (ALGO)
Let’s do another example. Algorand (ALGO) is a newer PoS crypto on the block, having started 2.5 years ago. It’s got the 24th largest market cap of cryptocurrencies, and has risen up the ranks quickly. I picked ALGO for a couple reasons. It’s still viewed as an “up and comer” in the crypto community due to its low fees, high transaction volume, and fast speed. ALGO claims to have “transaction throughput on par with large payment and financial networks.” Second, I’ve actually used it myself. I think ALGO is a cool technology, but does it deserve its $8.7 billion valuation?
Like our last example, I downloaded the total daily ALGO transaction fees and network revenue. A year’s worth of data wasn’t available, so I took the last month’s worth and multiplied by 12, which will almost certainly end up being an overestimate in ALGO’s favor as network usage has trended upwards over the past year. My result was $1,773,024.92 in total network revenue projected over a year. Here’s the proof of network activity trending upward over time to validate this claim:
According to the Algorand Developer Portal, 2.1 billion ALGO tokens are currently staked and participating in consensus out of a total circulating supply of 6.47 billion, a 32.46% staking rate.
Once again we can plug these variables into our valuation model:
And once again we end up with an absurd valuation, though slightly less so than our Cardano example. More evidence that cryptocurrencies are ridiculously overvalued and in a huge speculative bubble. Algorand investors should similarly expect to lose most or all of their money.
Implications for Bitcoin and other Proof of Work (PoW) cryptocurrencies
Obviously, my PoS valuation model does not directly apply to PoW coins, which currently includes the two largest cryptocurrencies by market cap, Bitcoin and Ethereum. A different, more complex and less quantitative model would be needed for PoW cryptos. Bitcoin enthusiasts love to claim that it’s “digital gold,” so the nebulosity of gold valuation models compared to stock valuation models is a suitable comparison here.
Rampant speculative fervor has infected the entire cryptoasset class. There’s no evidence that market participants in aggregate are making discerning decisions regarding Proof of Work versus Proof of Stake cryptocurrencies when they invest. Based on this, I think it’s fair to extrapolate and assume that the valuations of PoW cryptocurrencies are similarly distorted to grotesque levels just like my model indicated that PoS cryptos are.
You are not early.
There’s a common trope that floats around the cryptocurrency community. They like to repeat obsessively, “we are still early,” trying to convince themselves that they’re early adopters of the next big technological revolution. They fancy investing in cryptocurrency today akin to investing in Amazon or Google shortly after those companies went public.
Past returns are constantly trotted out to lure in new suckers. “Imagine if you invested in Bitcoin a decade ago, you’d be up a million percent!” Throw to the wind the fact that one of the first things that novice investors used to learn was that past returns do not indicate future results. Or that assets which don’t produce new value over time (like gold) usually turn out to be not-so-great for building wealth after all.
Full disclosure, I hold a very small amount of cryptocurrency that I earned through mining with my GPU, folding proteins for medical research, and playing the game Coin Hunt World. It’s a few hundred bucks out of my $278,000 net worth. I’ve never put a dime of my own money into this stuff (other than some electricity), and I’ve cashed out more for beer money than I currently hold. It’s a free slot machine spin and little more to me. I fully expect it to go to zero, or very close to it at some point.
Are there some cool, useful projects out there using blockchain? Absolutely. Brave Browser and their Basic Attention Token (BAT) is an example of a super interesting, consumer-friendly and potentially disruptive application, and I have used it. But the few crypto projects out there with actual use cases does not mean that they’re worth valuations in the billions.
Furthermore, the potential success and “adoption” of blockchain as a technology does not necessarily guarantee the success of cryptocurrency. Blockchain networks do not inherently require a token or coin to operate for those willing to trade off on decentralization. Shipping logistics and medical records are two examples where blockchain may be useful, but a cryptocurrency isn’t required.
By the way, if you truly believe blockchain adoption is inevitable, simply holding a total market index fund will accrue those benefits to you as the companies within your index fund adopt it and use it to create value in their businesses.
One thing is clear, and that is that the fundamentals of cryptocurrency as an investment make zero sense to any investor with a shred of rationality. As I’ve proven in this article, valuations are off the charts, way above what is reasonable for even a highly speculative growth investment. Your investment is backed by such a relatively small amount of earnings that it may as well not exist — the term vaporware is indeed apt here.
If you invest in cryptocurrencies, you are not early. You are incredibly late to what may be the first decentralized Ponzi scheme in history.