In our June 1 post, we created a hypothetical employee who just started their new job at the SEC and was tasked with reviewing a couple of recent alerts around crypto “investing.” In our last post, our hypothetical employee started his research by gathering insights from Warren Buffett. Now that the weekend is over, the research is continuing…
You wake up Monday morning and you actually can’t wait to go to work. You had a social gathering over the weekend and crypto was a popular topic. One of your friends was really bullish on XRP because they think Ripple is going to win their case against the SEC. You politely declined to participate because your employer is a party to the suit. In addition, you feel like you just now actually started thinking through what issues crypto raises from an investor protection perspective and you don’t want to take a position before you complete your research.
What the Buffett/Munger duo said continues to plague your thoughts. You badly wanted to convince yourself that they are just a couple of guys in their 90s. Extremely wise, but probably not up to speed on technology. Marc Andreessen, co-founder of Netscape and co-founder of the renowned venture capital firm, Andreessen Horowitz said the same thing.
The standard talking points around technology ring hollow though. “A car is also a technology,” you think to yourself. Of course, some of them partially run on software. “I really don’t know much about engines, batteries, or software,” you remind yourself. “I don’t need to. My primary interest in the car is the utility it provides me as it takes me from point A to point B.” That blockchain is a cool technology is already acknowledged by Bill Gates and Charlie Munger; but what is the actual utility of Bitcoin? You can hardly buy anything with it, the inflation hedge argument is mostly busted, its transaction speed is quite slow in comparison to other digital assets, nor is it clean. If it ever did have a chance of becoming a currency, that ship has largely sailed. “Its primary purpose,” you tell yourself, “is indeed speculation.”
Munger is whispering in your ears again: “A speculative medium that has no intrinsic value.” What book talked about intrinsic value again? You are looking at the small office library that you assembled on your first day at work. You are rather proud of it. It contains all the books from your studies, a large collection of finance books and a few you are looking forward to reading.
There it is… Damodaran on Valuation. You start flipping the pages and it doesn’t take long to find what you were looking for. On p. 10 it says:
We buy most assets because we expect them to generate cash flows for us in the future. In [Discounted Cash Flow] valuation, we begin with a simple proposition. The value of an asset is not what someone perceives it to be worth, but rather it is a function of the expected cash flows on that asset.
And what about intrinsic value? Yes, there is a blurb on that on the same page:
Using DFC models is in some sense an act of faith. We believe that every asset has an intrinsic value and we try to estimate that intrinsic value by looking at an asset’s fundamental value. What is intrinsic value? Consider it the value that would be attached to an asset by an all-knowing analyst with access to all information available right now and a perfect valuation model.
Before you start thinking about crypto, your mind briefly takes you to gold. You remember what Buffett said about gold: “[All the gold in the world] isn’t going to produce anything. [It] will just sit there and stare at you.” You realize that when Buffett says it doesn’t produce anything what he means is that it doesn’t produce any cash flows.
It’s all coming back to you now. Damodaran covered this not only in his books but also in his blog, Musings on Markets. You vaguely remember an old post on gold and intrinsic value. Your favorite search engine to the rescue!
I know this post will strike some of you as splitting hairs and an abstraction but it is a topic that fascinates me. A few weeks ago, I got an email asking a very simple question: How do you estimate the "intrinsic" value of gold? This, of course, raised two key questions:
a. What is intrinsic value?
b. Does every asset have an intrinsic value?
Splitting hairs? Damodaran obviously could have not foreseen that what seemed like splitting hairs at the time would turn into a legal question with billions, sometimes hundreds of billions at stake (Ripple, Coinbase, Elon, Binance, Dapper Labs, etc.) Ultimately, one way or another, all these disputes come down to the definition of investing. In any event, here is how Damodaran defines intrinsic value:
On the first question, here is my definition of intrinsic value. It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. The essence of intrinsic value is that you can estimate it in a vacuum for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information). At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.
What if there are no cash flows?
This definition then answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is in [sic] entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.
You reflect on gold again - it obviously does not generate cash flows. Therefore, what comes next does not surprise you:
In closing, though, let me try to answer the question that triggered this post: what is the "intrinsic value" of gold? In my view, gold does not have an intrinsic value but it does have a relative value.
But can someone invest in something when there is no intrinsic value? Not according to Damodaran:
To invest in something, you need to assess its value, compare to the price, and then act on that comparison, buying if the price is less than value and selling if it is greater. Trading is a much simpler exercise, where you price something, make a judgment on whether that price will go up or down in the next time period and then make a pricing bet.
You feel like it is coming together. You stop reading for a moment, get up like you always do when you are excited and start scrabbling a few words on your whiteboard, another source of pride. You always liked to use the whiteboard to brainstorm. You write:
No cash flows → No intrinsic value
GOLD has no cash flows → GOLD has no intrinsic value
No intrinsic value → Not investing
GOLD has no intrinsic value → GOLD is not investing
But Bitcoin, the so-called “digital gold,” does not generate cash flows, either. You hesitate for a brief second, but it becomes fairly obvious that 10 more seconds with the eraser and marker is all you need. You erase gold and replace it with Bitcoin. Here is what your whiteboard says now:
No cash flows → No intrinsic value
BITCOIN has no cash flows → BITCOIN has no intrinsic value
No intrinsic value → Not investing
BITCOIN has no intrinsic value → BITCOIN is not investing
Did Damodaran say anything about that? You go back to the article you were just reading, and yes, of course he did. You scroll down, and there it is, with emphasis and all:
You don't invest in Bitcoin, you trade it: Since you cannot value Bitcoin, you don't have a critical ingredient that you need to be an investor. You can trade Bitcoin and become wealthy doing so, but it is because you are a good trader. (emphasis original - underlined)
What else did he say? A few clicks, and you come across this video:
Bitcoin seems to be primarily a speculative game… This is an incredible show to watch. But it’s definitely not an investment, it’s not an asset class.
Now this is really nagging you. The legendary investor who ran circles around the S&P index for 57 freaking years and one of the most respected academics that you know, with the nickname the “Dean of Valuation,” who has educated countless MBAs, are both saying the same thing. There is no daylight between them. Bitcoin is a speculative tool and you cannot invest in it.
You sigh; what you found doesn’t surprise you but you truly wish it were the opposite. “Bitcoin is speculation,” you say. Out loud, you shout, “But that’s not what our alerts are telling the public!”
You want to think this through some more though. “Damodaran is an academic. A great one, for sure, but he is commenting on all of this from the ivory towers of academia.” You are trying to remember who said Wall Street looks very different when you are in it versus when you are looking at it from the halls of academia, or something like that, but it just doesn’t come to you. Perhaps they had a point. You will continue your research tomorrow, but you are interested in understanding the point of view of someone who is in the industry. Would a banker work? Jamie Dimon comes to mind…