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Digital Derivatives Weekly
July 2, 2020

Digital Derivatives – Is COMP 5x Overvalued?

Jitender TokasChief Business Officer

Governance tokens, starting with COMP with BAL close on its heels, have taken the DeFi world by storm. COMP is currently trading at $192,  up 185% in the last two weeks. The token’s current circulating supply based market cap is $569mn and total supply based market cap is $1.92bn. On both the metrics, COMP has shot past MKR to become the number 1 DeFi coin. 

Given the cascading effects the ongoing liquidity mining of COMP is having on the entire DeFi ecosystem, it is quite important for market participants to understand how to value governance token. In this article, we discuss how stock markets value voting rights and provide a valuation framework for COMP and other such governance tokens. Based on some reasonable assumptions, we estimate the value of COMP to be $40

Taking a Cue from the Stock Markets

Equity shares with differential voting rights are not uncommon. Broadly speaking, a company can issue three types of stocks from the perspective of voting rights – (a) normal voting rights stocks (1 vote/ share), (b) no voting rights stocks (0 vote/ share) and (c) super voting rights stocks (e.g 10 votes/ share). 

For a given company, stocks with differential voting rights tend to trade at different prices. Stocks with superior voting rights tend to be at a premium to stocks with inferior voting rights. The presence of voting rights related premium/ discount implies that the market ascribes economic value to voting rights. Let’s understand this with an example.

Consider a hypothetical company that has two classes of stocks that are publicly traded. 

Class A: N1 shares with 1 vote per share, currently trading at price P.

Class B: N2 shares with 0 vote per share, currently trading at price P*(1-D).

So, the non-voting stocks are trading at a discount of D relative to the stocks with voting rights. Obviously, the market value of the company’s equity (MVE) is equal to the market caps of the two classes of stocks, i.e.,

MVE = N1 * P + N2 * P*(1-D)

We can also write the MVE as the sum of value from cash flow rights and value from voting rights, i.e.

MVE = Value_CashFlow_Rights + Value_Voting_Rights 

Both Class A and Class B stocks have equal rights on the company’s future cash flows. This means that the price of the non-voting stocks can be thought to reflect the value accruing from cash flows alone. Therefore, we can write:

Value_CashFlow_Rights = (N1 + N2) * P * (1-D)

Using the above three equations, we can derive the market implied value of voting rights as:

Value_Voting_Rights = MVE * D/ (1 + (N2/N1) * (1- D)) 

So, what part of a company’s market cap can be attributed to voting rights is a function of the discount of non-voting shares (D) and the number of non-voting shares as a fraction of the number of normal shares. 

Several researchers have studied the differential pricing of different stock types and found that the price discount of non-voting stocks relative to voting stocks tends to be in low single digits (averages around 5%). It is however important to note that the stock markets are quite efficient, and the price differential between voting and non-voting stocks tends to reflect the unique characteristics of the company that drive the value of voting rights. 

For example, Google has two classes of listed shares: 

  1. GOOGL: Class A shares with 1 vote per share
  2. GOOG: Class C shares with 0 vote per share

Both these stocks trade at almost the same price. So, in this case, the market is not ascribing any value to the voting rights that GOOGL shareholders have. This is so because Google has a third class of shares (Class B) which are : (a) not publicly traded, (b) controlled by the founders, and (c) have majority of the voting rights. Because of this, the market believes that voting rights of Class A shareholders come without any real power and hence, the absence of premium for those rights.

Circling back to our hypothetical company, let’s see the value of voting rights change with the discount, D. For the sake of simplicity, we assume N1 = N2.

Non-voting share discount (D) Value of Voting Rights
5% 2.56% * MVE
10% 5.26% * MVE
20% 11.11% * MVE
25% 14.29% * MVE

 

The data in the above table, combined with the average discount of non-voting stocks, clearly indicates that voting rights tend to account for a rather small percentage of a company’s market cap. Using these insights, we can create a framework for thinking about valuations of governance tokens. 


Valuation Framework for Governance Tokens

For a given protocol, governance tokens can be valued using a two step process: 

  1. determine the ‘market value’ of the protocol
  2. determine what percentage of this value can be attributed to governance rights

Economic Value (EV) of a protocol 

A protocol in itself doesn’t have any value, but businesses built on top of a protocol certainly do. Since these businesses leverage the protocol to create value for their stakeholders, the cumulative value created by businesses using the protocol can be considered as the EV, i.e. the market cap equivalent, of the protocol. 

Another way of looking at it is this: a protocol must create some economic value. If there’s no resulting economic value, then as a corollary the rights to govern the protocol cannot have any economic value. 

EV attributable to governance 

Publicly listed companies are run by a board of directors that have a fiduciary responsibility towards all shareholders (including those that do not have any voting rights). Moreover, governments have created regulatory bodies to oversee listed companies and protect the interests of minority shareholders. All this monitoring and oversight does tend to limit the power and hence value of voting rights. 

Crypto protocols on the other hand are starkly different. There’s no board, there’s no regulatory oversight. This means that people with governance rights have a lot more freedom. Consider the limiting case in which there’s no overlap between the stakeholders of businesses leveraging the protocol and the holders of  the governance token of the protocol.. It is not a given that the interests of these two groups will always be aligned. For example, governance token holders can change the rules to create cash flow streams for themselves by ‘taxing’ the users of the protocol.

We believe that it is clear that governance token holders can have an outsized impact on the EV of a protocol compared to the impact voting right holders can have on a company. Therefore, share of governance tokens should be certainly higher than the 5% handle we saw in stocks. We believe that it should be closer to 20%, i.e. governance tokens will capture around 20% of the EV of protocol.


COMP Valuation

Economic Value (EV) of the Compound Protocol

The Compound Protocol is a money market protocol which enables people to lend/ borrow. Can we value it like a bank? Valuation of a bank is typically just a multiple of the size of its book.  Banks’ earnings can be roughly written as: (interest earned on loans – interest paid on deposits) times book size. Hence, P/B (where B is the 1 year fwd book value) multiple based valuation makes sense.

We could think of the Compound Protocol as a way to disintermediate banks by enabling lenders and borrowers to deal with each other directly. This means that the value that would have been captured by the bank now gets distributed across the borrowers and lenders. Therefore, we can estimate the economic value the Compound Protocol has generated for the lenders/ borrowers by putting a hypothetical bank between these borrowers and lenders and finding the value of that bank.

As of now, lenders have supplied assets worth $1bn to the Compound market, out of which ~$400mn have been borrowed. So, the current book size of the hypothetical ‘Compound Bank’ is ~$400mn (because interest is paid only on the borrowed assets). 

There are a few things to consider here:

  1. The book size has grown dramatically since the launch of COMP. Can the current size sustain or continue growing? 
  2. All the loans on Compound are overcollateralized, in contrast to traditional banks where most loans are uncollateralized. While overcollateralization reduces the probability of default and hence interest rates, it also increases the burden on borrowers and thus also tends to be a drag on growth.

 

Value of COMP

COMP Value = (EV of COMP Protocol * %ValueForGovernance) / #COMPTokens

                     = (1yrFwdBook * Target_PB_Mulitple * %ValueForGovernance) / #COMPTokens

Our assumptions:

  1. %ValueForGovernance = 20%
  2. Target_PB_Multiple = 5x. For typical banks, this number doesn’t exceed 2-3x. A higher multiple aims to capture the future growth potential.
  3. 1yrFwdBook = $400mn. We have assumed that part of the recent growth in the book will unwind as liquidity mining related benefits normalize. 

 

Plugging in these assumptions, we get COMP Value of:

COMP Value = ($400mn * 5 * 20%)/ 10mn = $40

We have clearly stated the assumptions that we have used to estimate the value of COMP. You should certainly question our assumptions and come up with your own assumptions to arrive at your own estimate.


Closing Remarks

We have made several assumptions, all reasonable and intuitive in our view, to arrive at an estimate of the value of COMP. You should certainly question our assumptions and change them as you see fit. But fixating on the value estimated by us alone would be akin to missing the forest for the trees. The aim of this report is to give the people in the ecosystem a framework for valuing governance tokens. The success of COMP will inevitably result in many more governance tokens to hit the market. If we are to avoid creating pump and dump cycles, we need market consensus on how to value these tokens.

Disclaimer

This analysis is for educational purposes only. This is not financial/ investment advice and should not be used to make buy or sell decisions. The authors of this article and Delta Exchange do not have any financial interest in COMP.

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