Confusion about Investment
When I first entered the industry, I often felt confused:
Is investing in blockchain projects a value investment or purely speculation?
If it is a value investment, why do many obvious scam projects still make good profits?
If it is purely speculation, then is industry research still useful?
How to judge the value of projects in the primary market?
Why do scam projects sometimes generate higher returns than so-called "value investments"?
Why do some people believe that VC investments are disconnected from the "market"?
Origin of the Stock Market
To answer these questions, it is not an easy task, but before we begin, we need to understand the history of the traditional investment market - the stock market.
In the beginning, entrepreneurship was in the form of unlimited liability partnerships. With the emergence of capitalism, large-scale industries began to appear, and a new organizational form was needed to encourage investment and entrepreneurship while limiting the liability of investors. Thus, the joint-stock company was born: the ownership of the company was divided into transferable shares, and the liability of shareholders was limited to the value of their shares.
At the same time, the shares of entrepreneurs and investors were locked in the business entity. In order to allow for effective exit and entry of both parties, an open market for trading company shares was urgently needed, and stock exchanges were established. For example, the London Stock Exchange was founded in 1698. With the advancement of capitalism and globalization, the stock market gradually expanded worldwide and became the main place for companies to raise funds and investors to invest.
Evolution of Valuation Methods
With this came another question: how should stocks be valued?
The first method that appeared was the "payback period" valuation method, which calculates how long it takes to recover the investment cost. Assuming a stable income industry with a net profit of 100 million in a year, if all the profit is returned to shareholders, then investing 500 million to purchase shares would mean that the cost can be recovered in about 5 years. Later, this method became fixed: dividing the stock price by the annual profit, thus the "payback period" valuation method evolved into the "price-to-earnings" (P/E) valuation method, which resulted in two valuation parameters: the P/E ratio and the EPS coefficient.
Therefore, the price-to-earnings valuation method is essentially a rough estimate of the "payback period". Does this sound familiar to the Bitcoin mining community? Yes, currently, one valuation method widely used by the mining community to purchase mining machines is the "payback period", which corresponds to the stock market's "price-to-earnings" ratio.
The payback period or the price-to-earnings valuation method is a "static valuation method" that does not take into account future changes. With the development of financial theory, more and more financial practitioners have come to realize the significance of the time value of money. For example, in the same industry, Company A has a net profit of 100 million this year, expected to be 200 million next year, and 300 million the year after, while Company B has a net profit of 100 million this year, expected to be 100 million next year, and 50 million the year after. What is the difference in valuation between these two companies? Expectations are a kind of "expectation" for the future, and this expectation is based on probability, so there must be a valuation method to reflect this expectation and risk, thus the "Discounted Cash Flow" (DCF) valuation method was developed. The specific mathematical formula is not analyzed in detail here, but it is important to understand that the DCF valuation method essentially uses the expected profit earnings in the future, adjusted by the "risk-free rate" and "risk premium", to obtain the present value.
Thus, the price-to-earnings ratio and DCF became the two most important valuation methods in the capital market.
Efficient Market and Behavioral Finance
However, valuation is not such a simple matter. Can we determine which stocks are undervalued and which stocks are overvalued by just using a few formulas? The valuation methods mentioned above are very objective reference standards and do not consider subjective factors. This brings us to the field of behavioral finance.
Behavioral finance is an interdisciplinary field that combines finance, psychology, behavioral science, sociology, and other disciplines. It aims to reveal the irrational behavior and decision-making patterns in financial markets. Behavioral finance theory believes that the market price of securities is not only determined by their intrinsic value but also greatly influenced by the behavior of investors, that is, the psychology and behavior of investors have a significant impact on the determination and fluctuation of security prices. It is a theory that corresponds to the efficient market hypothesis and can be divided into two main parts: arbitrage restrictions and psychology.
In the 1950s, Von Neumann and Morgenstern established a framework for analyzing rational decision-making under uncertainty based on axiomatic assumptions, namely the expected utility theory. Arrow and Debreu later developed and improved the general equilibrium theory, which became the basis of economic analysis and established a unified analytical paradigm for modern economics. This paradigm also became the basis for analyzing rational decision-making in modern finance. In 1952, Markowitz published the famous paper "Portfolio Selection," establishing modern portfolio theory and marking the birth of modern finance. Subsequently, Modigliani and Miller established the MM theorem, creating the field of corporate finance, which became an important branch of modern finance. In the 1960s, Sharpe and Lintner established and expanded the Capital Asset Pricing Model (CAPM). In the 1970s, Ross established a more general arbitrage pricing theory (APT) based on the principle of no-arbitrage. In the 1970s, Fama formally formulated the efficient market hypothesis (EMH), and Black, Scholes, and Merton established the option pricing model (OPM). Thus, modern finance has become a logically rigorous discipline with a unified analytical framework.
However, in the 1980s, a large number of empirical studies on financial markets revealed many anomalies that modern finance could not explain. To explain these anomalies, some financial economists applied the research results of cognitive psychology to analyze investor behavior. By the 1990s, this field had produced a large number of high-quality theories and empirical literature, forming the most vibrant school of behavioral finance. Matthew Rabin, winner of the Clark Medal in 1999, and Daniel Kahneman and Vernon Smith, winners of the Nobel Prize in 2002, are representative figures in this field and have made important contributions to the foundational theories of this field.
In summary, various valuation models can help determine the intrinsic value of assets, but humans are irrational, and in the face of a real investment market, investors will have various "psychological biases" that lead to subjective undervaluation and overvaluation.
Retail Investors and Market Manipulation
With this basic knowledge, we can now try to analyze the blockchain digital asset trading market.
- Currently, native blockchain digital assets, unlike traditional stocks and bonds, do not have a unified valuation method, making it difficult to determine a widely recognized intrinsic value.
- If only blockchain technology is used to "issue coins" and map real-world assets (RWA), then valuation is relatively simple and certain.
- The blockchain digital asset trading market is currently dominated by retail investors, and irrational trading behavior is particularly significant. Moreover, market regulation is unclear, resulting in many market manipulation behaviors, which further exacerbate irrational trading behavior.
Many people still do not understand why a investment market needs regulation. Their thinking is, "If someone is willing to manipulate the market, they will definitely drive up prices. How can we make money if prices don't go up?" In fact, it is this market manipulation that seriously damages the entire trading market valuation system and promotes irrational speculative behavior.
Let's look at some examples. In the traditional stock market, in the same industry, Company A is excellent and Company B is inferior. According to valuation models, Company A should have a higher valuation than Company B. Therefore, VC and private equity firms would actively invest in excellent entrepreneurs and help them develop their companies, which would result in good financial returns for themselves. Secondary market investors would also be willing to buy and hold shares of Company A, supporting the company's valuation and allowing shareholders to receive good returns. It can be said that entrepreneurs, VC investors, and stock investors all win. But if Company B is manipulated in the market, with someone manipulating prices, resulting in the stock valuation of Company B being much higher than that of Company A, what would the market's reaction be? Would VC investors still be willing to invest in excellent entrepreneurs (after all, good startups do not necessarily have good returns)? Would secondary market investors still be willing to buy shares of good companies (after all, stocks of garbage companies may rise even higher)? Would entrepreneurs still be willing to establish good companies (after all, stock prices do not reflect the quality of the company)? This becomes a lose-lose market. Over time, when efforts do not yield returns, this market will gradually decline.
So, do blockchain digital asset investors find this familiar? Yes, the current chaos in the market is largely due to high levels of manipulation and unclear regulation. When the market value of a so-called meme coin is higher than that of a so-called value coin, the lack of clarity in valuation affects VC investments and the participation of entrepreneurs, ultimately affecting secondary market holders. After all, valuable assets may not necessarily make money, so why not go all-in on the most hyped coin? Of course, the outcome is inevitably a crash, it just depends on whether the holders will exit in time when they make money.
Token Empowerment
In summary, the clarity of regulation for blockchain digital assets is actually the biggest advantage. It can help the industry develop healthily and enter a positive cycle, achieving a win-win situation for VC investors, entrepreneurs, and secondary market investors. But before that, the industry will go through a period of dark and disorderly exploration, with a mix of value investment and pure speculation: some projects are obviously scams, but the main players will manipulate prices, some good projects do not empower their tokens (like UNI), so it is difficult to determine their valuation, and some projects are average but have good token empowerment. From my personal perspective, the degree of optimism is as follows:
- The project is average but has good token empowerment.
- The project is excellent but has poor token empowerment.
- The project is a scam but has a good price trend.
Some may ask: why don't some good projects empower their tokens? It is also due to the lack of clear regulation. Take UNI as an example, in general, empowerment often involves the redistribution of benefits (repurchase or dividends), and this distribution is a typical securities activity, which will inevitably be subject to strict regulation. In order to avoid regulation, teams naturally create some vague "governance tokens". As for what kind of projects to look out for, it actually depends on your worldview (value investment or speculation).
Funds Driven or Innovation Driven
Another typical sign of an irrational market is "funds-driven". It is well known that in the past 10 years, the cryptocurrency market has experienced a bull and bear cycle approximately every 4 years, corresponding to Bitcoin's halving cycle every 4 years. Why? The reason is well known: halving every 4 years leads to a significant reduction in the volume of funds available for market manipulation.
On the other hand, a mature and rational market is typically "innovation-driven", where the valuation of the trading market is based on innovation that enhances the industry. Of course, this enhancement is not limited to efficiency improvement. In my article "My First Principles Thinking on the Blockchain Industry," I mentioned that the internet focuses on efficiency, while blockchain networks focus on decentralization and fairness. They are not a replacement relationship but a "complementary worldview". Considering the world's population of 6 billion, even if only 20% of the population focuses on fairness, that is still 1.2 billion people, and meeting the "worldview correctness" of these 1.2 billion people requires good technological means, which still requires high levels of innovation to support.
Fortunately, in the previous bull market cycle, we finally saw some cases of innovation-driven growth, which allowed innovators, primary market VC investors, and secondary market holders to achieve significant financial returns, providing the entire industry with an opportunity to enter a positive cycle.
Many people worry about the future macro-financial environment, such as interest rate hikes, CPI index, and unemployment rates. However, the emergence of AI has shown us that true innovation is not afraid of external high-interest rate environments. In the past two years, AI startups have not only received huge financing but also top performers in the secondary market, such as Nvidia, have tripled their stock prices in a year. This is the market's reward for innovation.
The same logic applies to the cryptocurrency market. If it truly enters a "innovation-driven" period, the 4-year cycle will no longer exist, and a high-interest rate macro environment will not be a problem. Instead, it will enter a long-term upward market like AI. This "innovation-driven" is not an easy task. It first requires VC investors in the primary market to be able to identify where true innovation lies. Furthermore, retail investors in the secondary market need to reduce various irrational investment behaviors. This disconnect between the rationality of the primary market and the irrationality of the secondary market will inevitably occur. We know that the vision of VC investors is generally forward-looking, but isn't this disconnect from the "market" also a kind of courage? After all, they are supporting the innovation of entrepreneurs in a real and tangible way.