The Investment Case For Ethereum (Cryptocurrency:ETH-USD)


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The investment case for different instantiations of blockchain technology, namely the Ethereum (ETH-USD) network, its native cryptocurrency Ether, and accompanying use cases like decentralized dinance, is similar to the internet in the late 1990s. Investors are getting in on the ground floor of a game-changing technology. There will be winners and losers, but there will certainly be an Apple or Amazon for many of the Pets.com. As of writing in early 2022, the crypto space is ~$2 trillion in value. Stocks as an asset class are roughly 50 times that, bonds and real estate are even bigger than that.

Many believe crypto can be a new asset class that can rival traditional investments. Crypto adoption was up over 100% in 2020 and 2021, even if it were to grow at only half that pace, in the next few years there will be well over a billion crypto users in just a few short years. A billion users is where the internet was in 2005. Only about 14% of people in the U.S. – mostly high-income men – own cryptocurrency, which is a small fraction of those who own stocks, real estate, and other traditional investments. Only 36% of institutional investors currently are invested in digital assets. A 1% portfolio allocation from the institutional investor market would add another $6T in market cap to the crypto industry. The opportunity in the space is immense. While it may seem like crypto has been around for a while this still may be the ground floor.

Ethereum is well-positioned to be in the driver seat to capture the rapid growth and user adoption projected in the coming years. The protocol has the security and decentralization to rival the most secure protocols like Bitcoin while having the flexibility necessary to allow for innovation. Use cases for Ethereum like DeFi, DAOs, NFTs, and the like have created real tangible demand for the network. Current issues such as high transaction costs, high environmental costs, and limited network throughput, will have to be addressed in the coming years for Ethereum to meet its full potential.

The core development team has specific items on their roadmap to address these items (transition to proof or work, sharding, etc.) but it remains an open question as to if and when they can execute. External regulatory issues also remain as a broader issue for the crypto and DeFi space. If these issues and concerns are mitigated, Ether the currency may well be in for some substantial appreciation in 2022. As we review in this paper a price target of $10,000 or more for Ether by the end of 2022 is reasonable when put in context.

What is Ethereum?

Ethereum was created by programmer and former Bitcoin enthusiast, Vitalik Buterin, to try and improve on some of the shortcomings of Bitcoin. Bitcoin uses the blockchain technology essentially just to create and send internet money. It’s a digital ledger tracking how bitcoin is moved between different parties. It’s a very simple but elegant computer code. Ethereum is a “Turing complete” virtual computer in that it has no limits to what it can compute. This gives programmers and developers endless flexibility in what they can build, including a groundbreaking use case in smart contracts.

Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met. They enable instant, permissionless and trustless value transfer without direction or input from any user. For example, two untrusted parties can execute a trade between them, sell a house, transfer a title, exchange a digital painting, etc., if certain criteria have been reached. In late 2021 Ethereum is on track to generate $10b in revenues driven by the smart contracts that run on its network.

At this pace, Ethereum would rank as the 5th largest software company based on revenue in the world. A large part of the bull case for smart contract platforms like Ethereum is that they continue to disintermediate centralized finance and build out decentralized finance or “DeFi.” DeFi cuts out a host of legacy payment, lending, exchange and other financial intermediaries. The bear case mainly centers around user adoption, sometimes high costs, limited throughput, and government regulation. Some concerns with the cost and speed of the most popular smart-contract platform, Ethereum, in part, led to the rise of competition which we will discuss shortly.

In 2022, Ethereum will switch to proof of stake from the proof of work system we described above. This new version is referred to as Ethereum 2.0 or ETH2. In proof of stake, owners of the cryptocurrency put up Ether as collateral to validate transactions. They take a small transaction fee for providing this service of securing the network. They put up their cryptocurrency, risking some of it in the event they are not honest in verifying the transactions of the network. They get rewarded for validating blocks in this system as compared to the miners who get the rewards in a proof of work system. Proof of stake is 99% less energy-intensive than proof of work.

Proof of work also inherently increases some of the sell pressure on the token. Miners who are rewarded with a cryptocurrency generally have to sell it daily or monthly to pay for their server and utility costs. In proof of stake there are no miners, so there is less sell pressure. Additionally, stakers receive most of the yield the miners used to make. This makes staking an attractive proposition. At the current estimate of the number of stakers when Ethereum transitions to ETH2, with the current level of network activity on the Ethereum network, yields for being an Eth staker could start off over 20% per annum; this figure will move lower as more stakers come on board. The below illustration provides some more color of the differences between the two systems.

1039731 16413884228029542

Source: Blockgeeks

Further down the Ethereum roadmap, likely by late 2022 or early 2023, there are plans to increase speed and reduce cost for network users through a process called sharding. The specifics aren’t important to a piece like this, but experts believe this upgrade will give the network Visa-like speed at minimal cost. With all of that context in mind let’s dive into some of the main use cases for the Ethereum network and why I think it unlocks one of the best investment opportunities on the board at the current juncture.

Decentralized Finance

Smart contracts cut out the middlemen of traditional finance to allow for DeFi. They cut out the need for lawyers to create and review lengthy contractual agreements. Everything is black and white in the code. Global banking revenues today are in the neighborhood of $3T (3.4% of global GDP and 3% of global investable assets). Against that, Ethereum mining revenues were roughly ~$20B in 2021, representing only <1% of the global banking pie. Given the way DeFi cuts out the cost of many different middlemen, and operates at faster speed than legacy transactions, it’s hard not to see that growing without the impediment of regulators. Let’s run through a few of the DeFi specific use cases.

1039731 16413884231783304Source: BitWise

Trading (Automated Market Makers)

Trading today is extremely centralized in the traditional finance world. Five exchanges control 50% of the volume of all stocks. In a traditional exchange like the New York Stock Exchange buyers and sellers offer up different prices until they come to an agreement on a sale price. Only a small subset of the traditional finance world has access to the full order book of prices, limiting price discovery for everyday users. Liquidity can also be limited on certain securities. DeFi solves these problems with an innovation called automated market makers (AMMs). AMMs are essentially exchanges for swapping one cryptocurrency for another. An exchange rate is maintained, for example 10 ETH to 1 BTC, in a “liquidity pool”. This is a pool with a variable exchange rate between two currencies. The AMM facilitates a price for transactions based on the supply, demand and liquidity in a pool. The pool is filled by investors who are incentivized to put money into it to earn a yield. They earn this yield by putting up their tokens on both sides of the pool. They incur the risk they could lose some or all of their investment if there is a run on liquidity.

The AMM is a smart contract so there is no need for human interaction. You trade with the liquidity pool and no counterparty. The only fees are the ~5-10bps (for major currency pairs) the protocol charges. For that fee you can trade assets with transparency into the cost ahead of time, anonymously, and for most well-known assets, in fairly large volume. There is an additional cost to use the Ethereum network that these AMMs are built upon but in the future this will move close to zero. Popular protocols like Uniswap, PancakeSwap, and SushiSwap are now generating well over $300 million a month revenue at almost zero operating cost and have millions of monthly active users.

1039731 16413884218772845

Source: The Block

Borrowing and Lending

Borrowing and lending on the blockchain use a system of smart contracts to match counterparties with no middleman. Users don’t have to trust in a third-party bank but only the code the protocol they are using is written in. Popular protocols like Aave, Compound and Maker, ask users to deposit funds they wish to lend into a pool from which borrowers can take out a loan. Lenders must post collateral of 80% of the asset they are borrowing. Lenders earn yield based on the demand and liquidity for the asset. This smart contract-based structure allows for almost real-time lending. To judge the use of this market we use a metric called total-value-locked (TVL). TVL measures the cumulative amount of assets that are staked or put at risk on a particular protocol. As of December 2021 over $30B in assets are staked in the top lending protocols. In total over $100B is in use in DeFi protocols. Institutions and governments are already beginning to use this new technology. In 2021 the European Investment Bank (EIB) raised 100 million euros through an Ethereum smart contract.

Additional use cases

We’re just scratching the surface here, but for the sake of brevity let’s go rapid fire. Insurance is on the blockchain. Current protocols allow users to get coverage for certain risks (mainly against smart contract failures and the risks related to their deposited crypto assets) without any centralized insurance intermediary. Asset management firms are springing up allowing you to manage all of your coins in one simple interface. Derivatives have been created to allow users to trade the values of various assets on the blockchain network without needing to hold the underlying assets (see: Synthetix, dXdY). Digital assets pegged to real-world currency (stablecoins) have been created for easy on and off-rails for users. Prediction markets are springing up for punters to make bets on-chain (See: Polymarket and Auger). Compliance and KYC platforms have been created to understand who is behind a transaction before you engage with them.

Again, we’re really only getting started with DeFi. Anything and everything in traditional finance has the possibility to be disintermediated by a DeFi protocol. There is also plenty we haven’t even thought of yet you can do when you have instant, frictionless, anonymous transfer of funds.

Web3

Web 3.0, or Web3, is the shorthand for the decentralized internet. Web 1.0 was read-only: think blogs. Users were consumers. Web 2.0 is read/write: think Facebook or Reddit. Users and their data were the product. Web 3.0 is read/write/own. Users own their data. In the previous models, your data and content was owned by Facebook (NASDAQ:FB) or Google (NASDAQ:GOOG) or whoever. In Web3 you own your content, you own your data, and can benefit from it in perpetuity. You take it with you whenever you leave a website. Web3 breaks the centralized legacy model of the internet to be more flexible and democratized for its users.

1039731 16413884227232974Source: A16Z

Cryptocurrencies enable Web3 because they enable direct connection between the content and the creator through the blockchain. This allows for also allows the user to lay claim to their data via the blockchain. Whether that data is your habits on a website or a digital file you created. This allows users to be able to directly monetize content as long as they wish, and as long as there is interest. For example, an artist can create a digital piece of artwork and receive 10% of every future sale. This is not possible in the legacy art world.

Web3 also allows you to have a portable digital identity. Now instead of signing in with Facebook you can sign in with Dunleavy.eth using your digital wallet. Your assets and identity come with you onto the portal. Once you leave everything comes with you. You are no longer the product, forcing Web3 sites to create real value to continue to attract users. This digital identity allows you to prove what you own online and also maybe even build a digital resume. Were you an early adopter of an interesting project? A successful investor in a new protocol? Attended an event that provided you a token for attendance? All of this is possible to track and verify in Web3. Let’s discuss a few of the major instantiations of the nebulous term that is Web3.

DAOs

This model allows for the creation of decentralized autonomous organizations, known as DAOs. DAOs act as decentralized companies native to the blockchain. Each DAO usually creates its own token where users can vote (like shareholders in a company) on protocol matters. DAOs are owned by their token holders. They are able to raise money from investors and act as voting, legal entities on the Ethereum network. Their native cryptocurrencies don’t act as currency but as a voting token on what the organization will do with the capital it raised through the token sale.

There are billion-dollar DAOs already acting as decentralized corporations in 2021. There are DAOs raised by investors to buy specific sets of items, DAOs that manage blockchain smart contracts, DAOs that curate art, DAOs that even come together just for one specific project and then disband. Some experts think we will reach a point where a majority of future organizations are DAOs.

1039731 16413884242486134

Non-Fungible Tokens (NFTs)

NFTs are tokens that represent the unique ownership of an item on the blockchain. NFTs are usually art, collectibles, online tickets or short video images (GIFs). No two NFTs are the same. NFTs are unique in that there is digital record and history on the blockchain of creation and ownership. They also allow some interesting things you couldn’t do with physical art or collections like allocating a percentage of all resales to be paid back to the original creator.

They are not only digital status symbols, but can be used to provide holder-only access to events or future distributions. They can provide a unique verification method through holding the NFT. Say a band wants to give free tickets to fans who attended the last 5 shows. All the fans have to do is show the 5 NFTs given to them for attending the shows and they are instantly given a ticket to the next one. Models like this are only just being explored.

Video games are another area of disruption. There have been numerous games created where players battle, breed, raise and trade NFT avatars similar to something like Pokemon – except for money. Games like Axie Infinity have become so profitable that some players in developing countries play them as their main source of income. The game generated $1.2B in 2021 alone. The NFT market as a whole grew from $340 million in 2020 to over $14 billion in 2021.

1039731 1641388420936427

Source: The Block

NFT profile pictures projects or PFPs have become the new Rolexes and Lamborghinis for flashing digital wealth and taste. The price for one image in the collections Bored Ape Yacht Club or Cryptopunks runs over $200,000 apiece. The most expensive of these images selling for well into the millions. These NFTs have also added on utility, for example entitling you to enter special events, receive special merchandise or receive revenue share in a project the community is building such as a casino or hotel. Most projects like these are bought and sold on the largest marketplace for NFTs, OpenSea. The first three days of 2022 combined saw a higher OpenSea sales volume than the entire first half of 2021! Coinbase one of the largest US exchanges is launching its own NFT marketplace, and already has 3 million people on its waitlist. Only around 300k people use OpenSea a month. The market is about to explode with new buyers. So it’s still early days here as well.

Metaverse

This is probably not its own category per se, but it’s such a big idea we are going to give it one. Web3 will be a foundational key to another futuristic concept: the Metaverse. The Metaverse is an online virtual world; think “Ready Player One.” Bulls see the metaverse as a place for a variety of social interactions and engagement leading to a huge opportunity for advertisers, artists and companies. Bears see it as a technologists’ overoptimistic dream that is likely to never come to fruition. Some of the leading Metaverse companies today already are growing like crazy. Virtual reality video games, Roblox, had users almost double in Q4 2020 alone.

Facebook pivoted its company strategy to focus on the Metaverse, even changing its name to Meta. Meta CEO Mark Zuckerberg hopes the metaverse will reach 1B people by 2030. The market could hit $800B by 2024. Microsoft launched its Metaverse product called Mesh, which allows people in different locations to join shared holographic experiences. They hope this will be the future where people can join virtual meetings, send chats, collaborate on shared documents and more.

What is the fair value for Ether?

When I first thought about how to value cryptocurrencies, I assumed valuation was all really based on sentiment mixed with a little bit of technical analysis voodoo. Hopefully, the above breakdown shows there’s more to the price of Ether than that; the Ethereum protocol has real revenue-generating companies built on top of it. Not a few dollars, we’re talking over $110B in deposits on exchange protocols already. So Ethereum isn’t really a company but it has company-like revenue. Let’s discuss some frameworks for how we can value the currency Ether from a few different angles.

Supply based (simple)

Let’s start simple. There are roughly ~118 million Ether in existence currently. Every time a new block is mined new Ether are created. With some recent upgrades to the network, part of this Ether reward is destroyed while some goes to the miners who put in the work to mine the block. The annual inflation for Ethereum through this process is about 1%, with the currency actually moving deflationary when the network gets particularly active. When Ethereum moves to Ethereum 2.0 and proof of stake, experts predict Ether will move to be net deflationary at around 2% annually mainly due to reduced issuance.

This is a fairly simple approach but theoretically this should make each Ether more valuable. The total supply is effectively also reduced by the amount of individuals who stake it and users who lock it for lending, collateral etc. This amounts to over 20% of supply already. It’s also fair to say that some of these assets will be lost over time due to poor security management by users or by someone dying and not passing on the location to the assets or losing their keys, etc. Net, net there is an even more deflationary benefit to most cryptocurrencies because of this unique aspect, that should boost price over time.

Fundamentals based

Ethereum is the current leader in revenue among layer-one blockchains by a pretty large margin. Those fees have only continued to grow at a faster and faster pace over time. This indicates a high amount of demand for the network relative to the competition, despite the growing number of competitors.

Total network revenue was up 500% year over year ended Sept. 30, 2021. Total locked value in DeFi was up 1200%. Exchange volume was up 300%. Daily active users were up 25%. Take that revenue growth rate and add in a price to earnings ratio for the protocol of ~30x-35x, and you have what looks like an insanely undervalued hypergrowth tech stock. P/E for crypto is a bit tricky so it’s hard to say this is exactly apples to apples to traditional finance because the fees for Ethereum currently go to miners. Ethereum doesn’t have costs but miners do, so there is no real EPS in a traditional sense, just revenues. In the future (proof of stake) these fees will go to stakers who have essentially zero cost.

Will that in mind I still think it’s useful to compare ETH to some of the traditional market leaders. For some perspective Apple has a price to earnings ratio of ~30x and is growing at around 10%. NVIDIA (NASDAQ:NVDA) ~70x p/e, ~20% growth rate. Google? 30x p/e, ~30% growth rate. What about stocks with a huge revenue growth rate how does Ethereum compare? Square (NYSE:SQ) has a 118% growth rate at a 155 p/e. Shopify (NYSE:SHOP) has an 85% growth rate at a 540 p/e. Tesla (NASDAQ:TSLA) has a 66% growth rate at a 346 p/e.

1039731 16413884221922824

Source: TokenTerminal

So, on a fundamentals basis, looking at its cash flows the Ethereum protocol is valued like a large tech company while growing like startup in hypergrowth stage. Competitors are much more richly valued based on p/e (see above), and if Ethereum’s multiples expanded to even get in the neighborhood of their p/e ratios there is a lot of room to run. We’re currently around a 40 p/e.

P/E

Ethereum Market Value at Current Earnings ($M)

25

$ 308.33

40

$ 493.33

50

$ 616.67

75

$ 925.00

100

$ 1,233.33

125

$ 1,541.67

150

$ 1,850.00

175

$ 2,158.33

200

$ 2,466.67

Source: Author calculations

Market cap based

Crypto is a roughly ~$2.0T market cap. The global value of all stocks worldwide is $100T, bonds and real estate slightly higher each. If Crypto is a new asset class, then we have 50x to go. You can pick plenty of losers and still win by finding a winner or two. On the coin level Bitcoin (BTC-USD) ~$900b, Ethereum ~$450b, Solana (SOL-USD) ~$50b, Cardano (ADA-USD) $40b, Polkadot~$25b, Avalanche (AVAX-USD) ~$20b. Apple (NASDAQ:AAPL) is worth ~$3T, Microsoft (NASDAQ:MSFT) ~$2.5T, Google (GOOG) $2T. If one of these provides the value of even one of these companies we still have a long way to run.

At ~25% of the total crypto market cap, Ethereum is likely to continue to appreciate nicely with the asset class even if you assume, they lose some market share. Currently Ethereum is roughly 20% of Crypto’s total market cap. If Crypto gets to a $10T industry (roughly the value of Gold) and Ethereum drops to 10% of the industry it still will more than double from its current prices. Crypto’s growth for the last 5 years has actually outpaced that of the internet in the same time frame, so it seems likely things are moving in the right direction (see chart below) for the asset class growing nicely to be a safe bet.

1039731 16413884228256192

Source: RealVision

Supply based (advanced)

Cryptocurrencies have predetermined issuance schedules far into the future. When changes are made to supply they can also be modeled out into the future fairly accurately. This makes them ripe for modeling based on the overall supply and demand for coins. This isn’t present with fiat currencies where issuance schedules can be changed by governments in short order. As a simple example the cost of keeping a crypto asset’s price stable is equal to the number of coins issued per day multiplied by the price per coin. If 5,000 Ether are issued each day at a price of $3,500 you would need roughly $17.5 million in demand to keep the price from dropping (assuming all of the miners who got rewards were selling).

Ethereum’s supply has daily supply has fluctuated, though it’s trending downward, and with an upcoming catalyst in Eth2 to reduce it by a substantial amount. With Bitcoin, the monetary policy hasn’t changed since its inception; the daily supply is known. The supply 50 years from now is known. With supply as a known constant the only variable is demand. The most popular model known as the Stock to Flow model noted below has been a popular and somewhat usual tool to predict the price of Bitcoin.

1039731 16413884241172674Source: PlanBTC

A similar model was built for Ethereum from DataAlways (below) based on an initial set of analysis by Nikhil Shamapant. As we mentioned earlier, supply for Ethereum currently is a bit more variable than Bitcoin, but trending toward a more known commodity with the upgrade to ETH2. Therefore, the challenge is estimating demand for a price target. Assuming the current rate of demand by network participants once Eth2 occurs in Q2 2022, Ether would be worth an estimated $80k per token.

1039731 16413884244106371

Source: DataAlways

1039731 16413884221625354

This model assumed there are a set ~10 million stakers dividing rewards, who sell all the Ether rewards once they receive them. If they chose to keep even half of their rewards the price targets get even more rosy.

1039731 16413884246051333Source: DataAlways

Comparative Analysis

Below is a chart from RealVision comparing Bitcoin’s rise over its first few years of existence. Ethereum’s rise follows that chart almost to a T. If the past is prologue, then Ethereum could hit the $20,000 range sometime in mid to late 2022. This sort of charting is a bit tough to call science but directionally it seems to make sense if you think of the growth of a new blue-chip cryptocurrency.

1039731 16413884250577543

Source: RealVision

Analogues to Bitcoin will seem to become less relevant as more and more people view the Ethereum network as something akin to a technology company or payments platform- though neither of these is a perfect comparison.

Industry Price Targets

In September, Investment bank Standard Chartered issued a long-term Ethereum projected value target of $26,000-35,000. In early November, Goldman Sachs issued an ether price target of $8,000. Fundstrat had said Ethereum can hit over $10,000. JPMorgan the other hand priced Ether at fair value of $1,500 in early November 2021. Overall, the finance industry remains fairly bullish on Ether.

Conclusion

The bottom line is that if Ethereum can maintain its current insane growth trajectory at current valuations, even if it isn’t 500% per year, it’s going to be really challenging for the price not to rise substantially in 2022. I also think the flows-based models have particular merit in a space where supply is a constant and the only variable is demand. We haven’t even really factored in the potential demand from institutions sitting on the sideline waiting for regulatory clarity (maybe like yourselves). We haven’t factored in the demand from the upcoming Ethereum ETF (the Bitcoin ETF took in $1B in just 2 days). We haven’t factored in the demand for folks who see a 20% yielding blue-chip cryptocurrency (yes that’s the projected yield on Ether after Eth2) and decide to come on board. This is as the asset is essentially being “bought back” at 2% per year due to its deflationary status.

In looking at all of the data and analysis, you have a range of targets from ~$1.5k to $150k. That’s a pretty big band. Given the catalysts above I am much more in the bullish camp, though maybe not to the tune of $150k. I think a $20k Ether by the end of 2022 is not unreasonable if the Ethereum 2.0 transition goes smoothly in Q2 2022. This would place the market value at around ~$2.4T or that of a large successful software company like Apple, Microsoft, Google, etc. Given the additional use cases, growth, current valuation and interest in the space, it sounds crazy to say but $20k almost seems reasonable.





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