Correct posture for analyzing FDV Do not be misled by the size of the valuation, consider the token dilution effect.
Proper analysis of FDV Don't be influenced by valuation size, consider token dilution.
Complete dilution market cap makes sense to some extent.
Original author: SAM ANDREW
Complete dilution market cap, usually referred to as FDMC or fully diluted value (FDV) in the field of cryptocurrency, is a concept that distorts the concept of the stock market into cryptocurrency. The concept aims to capture the dilutive nature of the protocol. However, there are flaws in the current way it is used and it needs to be updated.
This article explores the fallacy of the concept of “complete dilution market cap” in cryptocurrency and proposes an alternative solution.
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Market cap represents the equity value of a company in the public market. It is equal to the company’s stock price multiplied by the number of outstanding shares. The rise of technology companies in the 1990s gave birth to stock-based compensation systems. Companies began to pay employees with stock options. Stock-based compensation has several advantages. It aligns the incentives of the company and its employees. It is a non-cash expense. It enjoys favorable tax treatment.
Until recently, stock-based compensation was not reflected in the company’s income statement, nor was it a cash item on the company’s cash flow statement. It was an expense that did not appear anywhere. However, it would eventually be reflected in the number of outstanding shares. As the number of shares increases, earnings per share tends to decrease under other unchanged conditions.
Investment analysts adjust the number of outstanding shares to adjust for the virtual stock-based compensation expense. Analysts add the shares that will be issued to employees in the future to the existing number of outstanding shares. The sum of these two is called fully diluted shares. Fully diluted shares multiplied by the stock price gives the fully diluted market cap. Fully diluted shares and market cap are very common in equity investments.
Application to Cryptocurrency
A similar concept of market cap also applies to cryptocurrency. The market cap of a protocol is the token price multiplied by the number of circulating tokens. The number of circulating tokens is basically the same as the number of outstanding shares. However, unlike the number of outstanding shares of a company, the number of circulating tokens of a protocol often increases significantly.
Companies tend to avoid issuing stocks. Issuing stocks is equivalent to selling equity of the company at the current stock price. If a company is optimistic about the future, why sell equity at today’s price? This would dilute the value of existing shareholders.
On the other hand, protocols often issue additional tokens. Token issuance is part of their “business plan”. It all started with Bitcoin. Bitcoin miners ensure that transactions are correctly entered into the Bitcoin blockchain. They are rewarded with Bitcoin. Therefore, the Bitcoin network needs to constantly issue new Bitcoins to reward the network’s miners. Subsequent blockchains have adopted the same pattern: issuing native blockchain tokens to reward those who accurately input transactions.
The token issuance model that is inherent to blockchain means that there are constantly more tokens in circulation. Cryptocurrency market cap does not capture the number of future circulating tokens. Therefore, the concept of complete dilution market cap has been developed. The complete dilution market cap is the current token price multiplied by the total number of tokens to be issued. For protocols with continuously increasing token supply, data on the token supply ten years later is usually used.
Full dilution market cap makes sense to some extent
People rightly recognize that cryptocurrency market cap does not fully reflect the actual situation. Different measurement standards are needed to capture the impact of all future tokens to be issued.
At the same time, the “business plan” of the protocol is also evolving. The issuance of new tokens is no longer just for rewarding miners, as was the case with Bitcoin initially. Tokens are also used for network development. Token issuance can help guide the network to achieve its functionality. A network, whether it is Facebook, Uber, Twitter, or blockchain, has little practicality if not many people use it. But few are interested in becoming early users. Issuing tokens to early adopters gives them financial incentives to use and promote the network until others join and make the network itself practical.
Token issuance has also become a form of compensation for ambitious developers building protocols and the venture capital funds supporting them. There is nothing wrong with rewarding entrepreneurs, supporting venture capital funds, and early adopters. The key is that token issuance has become more complex.
But full dilution market cap also has flaws
There are many flaws in the logic of full dilution market cap.
1. Mathematical errors
For some reason, the cryptocurrency market believes that if a protocol issues more tokens, its value should be higher. This is completely wrong. In business, economics, or the cryptocurrency field, there is no example that issuing more things will increase the value of an individual. It’s a simple supply and demand relationship. If supply increases and demand is not met, the value of the thing will decrease.
FTT token is a typical example. Its token structure and mechanism are similar to other tokens. Before the collapse of FTX, the price of FTT was $25. The market cap was $3.5 billion, with 140 million circulating tokens. The fully diluted market cap was $8.5 billion, with a total circulating supply of 340 million tokens.
Therefore, by issuing an additional 200 million tokens, an increase of 2.4 times, the market cap of FTT also increased by 2.4 times… How does this make sense?
To truly reach a fully diluted market cap of $8.5 billion for FTT, the additional 200 million tokens issued must be sold to buyers at the current price of $25. But that’s not the case. The additional 200 million tokens issued are simply given away without any issuance revenue.
The table below illustrates the difference in FTT market cap and token price if the issuance of 200 million FTT tokens is compared to selling them. Token issuance simply adds 200 million tokens to the existing token supply, resulting in a fully diluted total token supply of 340 million tokens. Token issuance has no impact on FTT market cap. The expected impact is that the total token supply increased by 143% and the price per token decreased by 59%. This is simple math. The numerator is constant, while the denominator increases. The result is a smaller number.
Alternatively, if these 200 million FTT tokens were sold at the token price of $25 at that time, FTT would receive $5 billion in revenue, increasing its market value to $8.5 billion fully diluted. The circulating token count would increase to 340 million. Both the market value and circulating token count would increase by 143%. The end result is that the price per token remains unchanged.
The operation of stocks is similar to this. If Apple issues more shares to employees as equity compensation, it does not generate any revenue. As a result, the diluted circulating shares increase and the price per share decreases. If Apple sells shares to the market at the current price, it will generate cash revenue. Its market value will increase accordingly. The circulating shares will also increase. The end result is that the stock price remains unchanged.
Applying the logic of fully diluted market value in cryptocurrencies to stocks highlights its flaws. If this logic were true, then every company should issue more shares to increase its fully diluted market value. Obviously, this does not happen. According to the reasonable inference of this logic, the fully diluted market value of every company would be infinite. There would be no limit to the number of shares a company can issue. Therefore, regardless of a company’s size, growth potential, profitability, and return on capital, their fully diluted market values should be the same, that is, infinite. However, this is clearly not the case.
So, what about deflationary protocols?
Most protocols are inflationary, meaning that more tokens will be issued over time. Some protocols are or will become deflationary, meaning that the number of circulating tokens will decrease in the future. According to the logic of fully diluted market value in cryptocurrencies, deflationary protocols will have lower future value than today’s value.
Something in the future will decrease, yet its value will decrease because of its decrease. This makes no sense. It goes against the basic economic principles of supply and demand.
2. This implies impossible scenarios
The logic of fully diluted market value in cryptocurrencies implies impossible scenarios. If the fully diluted market value of FTT is $8.5 billion, and the market value is $3.5 billion, then the market implies that each person receiving the additional 200 million FTT tokens will create $5 value per token after receiving the extra tokens. As explained, there is no profit from the issuance of these 200 million tokens. Therefore, the only way to achieve a fully diluted market value of $8.5 billion is for those who receive these 200 million tokens to create $5 billion in value overnight.
But how can they do that?
How does delivering more tokens to people increase their market value? This is impossible. These tokens are likely to be stored in wallets as part of an investment portfolio. Receivers will do nothing except trade these extra tokens.
3. Unexpected Consequences
The unexpected consequence of the complete dilution market value logic of cryptocurrencies is the overestimation of the value of protocols. Investors, whether right or wrong, often believe that the larger the market value of an asset, the higher its value and stability. Investors feel reassured by the huge complete dilution market value valuation of these protocols, but often fail to realize the logical flaws in the calculation of complete dilution market value. In this regard, FTT is the main culprit.
When the price of FTT is $50, its market value is $7 billion, and the complete dilution market value is $17 billion. However, during that period, the average daily trading volume of FTT rarely exceeded a few hundred million dollars.
The huge complete dilution market value, small market value, and tiny trading volume are the reasons for the disaster. Some tokens executed this pattern during the peak of the cryptocurrency market. This setup makes market manipulation possible. The small trading volume allows a few parties to control the volume and thus control the price. The token price determines the market value, which ultimately determines the complete dilution market value. This means that tokens that are hardly traded or used for money laundering transactions support artificially overestimated token values, which are used as collateral for loans. It also conceals the actual size of the investment.
Today, assets with high complete dilution market value and low market value are not as common. But they still exist. The following table lists the number of protocols that have a multiple relationship between complete dilution market value and market value.
4. Token Issuance is Becoming More Like Stock-Based Compensation
Since Satoshi Nakamoto wrote the Bitcoin whitepaper, the purpose of token issuance has undergone significant changes. Issuance is used for various purposes other than rewarding network miners and validators.
Token issuance is becoming more like stock-based compensation in the cryptocurrency market. Protocols reward those who participate in building the network by granting them native tokens, just as companies grant employees, advisors, and investors stock options to reward their contributions to the company’s development.
Token issuance should be viewed as similar to stock-based compensation. Issuing tokens, just like issuing shares, is a cost for the protocol or company. It dilutes the circulating supply of tokens or shares. However, if done correctly, this cost is an investment. It generates returns. The granted stock to a diligent employee can create value for the company that exceeds the value of the granted stock. Similarly, network participants can create value for the protocol that exceeds the value of the granted tokens.
The returns generated from the granted stock or tokens may not be known until much later. Before that, a well-thought-out stock or token grant program is the best guide, indicating possible scenarios: a significant use of token distribution or severe dilution with no value.
Not all token allocations are equal
The fully diluted market value calculation includes all future token issuances. However, not all token issuances are the same. Some tokens are distributed to early adopters, some are allocated to the founding team, and others are given to early investors. Some tokens are allocated to the protocol’s foundation for future use. These include tokens allocated to the protocol’s reserve fund and ecosystem fund. They are tokens that will be used for the development of the network. Tokens intended for future investment in the network should not be included in the circulating token supply.
Tokens intended for future investment are equivalent to cash on a company’s balance sheet. Cash on the balance sheet reduces the overall value of the company. The overall value of a company is its enterprise value. The enterprise value reflects the value of all the company’s assets. A part of the enterprise value is the equity value of the company. For a publicly traded company, the equity value is its market capitalization. Another part is net debt. Net debt is total debt minus cash. The concept is that a company’s total assets are funded by equity and net debt. The table below illustrates how increasing cash reduces a company’s enterprise value under other equal conditions.
The value of tokens intended for investment is equal to the token price multiplied by the designated token quantity. This represents the funds that the protocol must invest. It is equivalent to cash on the balance sheet.
The table below mechanically outlines this logic. The example in the table outlines a protocol with 500 circulating tokens. An additional 200 tokens are issued to the reserve fund. These 200 tokens are designated for investment in the network. At a token price of $5, the market capitalization and fully diluted market value are $2,500 and $3,500, respectively. The value of the 200 tokens designated for investment in the reserve fund is $1,000. This $1,000 value should reduce the total value of the protocol, just as cash reduces the enterprise value of a company.
Tokens intended for future investment can be seen as shares that the company has not yet issued. The conclusion is the same as treating them as “cash”. Shares that Apple may issue in the future are not included in its fully diluted market value. Apple can sell shares to generate cash revenue. This cash can be used to develop Apple products. The future value of these products will ultimately be reflected in Apple’s market capitalization. Similarly, a protocol can issue tokens to its treasury to generate “cash” revenue for investment in its network. The difference is that for the protocol, “cash” is its native token. It doesn’t actually need to sell shares on the market to generate revenue like Apple does. In this case, the protocol is more like the Federal Reserve, which issues more currency to pay for expenses.
The difference lies in flexibility
The reason a protocol has so many tokens in circulation from the beginning is because its structure is very flexible. Companies can freely issue and repurchase shares, but they require approval from the board of directors and the ultimate shareholders. In contrast, protocols attempt to make token issuance and destruction much easier.
From the beginning, the protocol needs to determine how many total tokens will be issued and when they will be issued. This is a “everything is determined on the first day” mentality. Companies and the Federal Reserve do not operate with such strictness. The number of shares in a company and the amount of circulating dollars fluctuate according to market dynamics. The protocol needs to disclose a certain number of tokens because their tokens are used as currency value to reward network participants. If the token quantity is uncertain, participants will worry that the value of the currency they receive will depreciate due to token inflation. The cost of eliminating this concern is an inflexible token structure.
Exaggerated Fully Diluted Market Cap (FDMC)
Some protocols exaggerate the fully diluted market cap (FDMC). The token quantity used to calculate FDMC includes tokens issued to the protocol treasury for investment. The inflated token circulation quantity leads to an exaggerated FDMC. This further leads to higher valuation multiples.
For example, Arbitrum and Optimism exaggerate FDMC. Their FDMC includes the total number of tokens to be ultimately issued. However, in both cases, a large number of tokens are issued to the financial or equivalent department. These tokens are designated for investment in the ecosystem. By removing these tokens from the total token circulation, a more accurate adjusted token supply can be obtained, resulting in an adjusted market cap.
The table below shows the adjustments made to the token circulation of Arbitrum and Optimism. The adjusted token supply is 45% lower than the fully diluted figure.
So what is the correct token supply?
The circulating supply is correct to some extent. It reflects the current number of tokens issued. But it ignores the impact of future token issuance. The fully diluted supply is also correct to some extent. It reflects the total number of tokens to be ultimately issued. But it fails to adjust for tokens issued to the treasury. The adjusted figure should be based on the fully diluted figure and deduct the tokens issued to the treasury.
One thing is certain, the fully diluted market cap figure is misleading. Astute analysts should not exaggerate the protocol’s market cap based on future token issuance, but weaken the existing valuation by the dilutive impact of future issuance.