The metaverse is likely overvalued.
According to Crunchbase, funding for metaverse companies has increased from $5.9 billion in 2020 to $12.1 billion in 2021. It's hard to say if the valuations are inflated, even though most projects don't yet have a working product. The companies and projects that receive funding get that funding based on their potential.
It is not easy to determine if that potential is overvalued, but we can try. We can use valuation techniques from traditional finance and adapt them for these Metaverse companies to determine that maybe (just maybe) your favorite Metaverse project is overvalued, fairly valued, or even undervalued.
This post is part of CoinDesk's Metaverse Week.
How are companies traditionally valued?
When buying a company, the most important point is the valuation. And it's not particularly close. How much does Alice Bob have to pay for Bob's company? Regardless of how favorable the other terms are (payment method, closing conditions, breakup fees, etc.), you couldn't buy the Cargills' family business for $100 million.
Generalizing even further, price is the most important negotiating point in any financial transaction. In IPOs, follow-on equity offerings, leveraged loans, corporate bonds, Small Business Administration (SBA) loans, Series A rounds, and even the daily cup of coffee, price is paramount. In addition, negotiating a favorable valuation is one of the most important services provided by investment banks.
In these negotiations, bankers on both sides present myriad data points to support the proposed valuations. Usually, the valuation is presented in the form of a sales multiple, EBITDA (earnings before interest, taxes, depreciation and amortization), book value (excess value of balance sheet assets minus liabilities) or previous transactions (what your local real estate agent would call "comparables"). Sometimes bankers even use the darling of academics: discounted cash flow, which is supposed to estimate the value of an investment based on expected future cash flows. (What is usually concealed is the fact that a manager has manipulated the inputs to get the final number to go in the desired direction.)
That's all well and good, but this is crypto and this is Metaverse week. How does this ancient wisdom apply to the world of metaverse investing? Does any of it apply? How much should investors pay for these metaverse projects?
So how do you value a metaverse project or token?.
Unlike traditional finance, there is no proven method or CEO here to tell me what to do. Faced with endless, paralyzing possibilities, I settled on one main metric.
Users.
Why users? For all the incoherent technobabble, the Web 3/Metaverse folks and thought leaders have made it abundantly clear that they ... whatever it is ... are doing for the users. The Metaverse can mean many different things, depending on who you ask. It's either about games, augmented reality, non-fungible tokens (NFTs), or some combination thereof. For simplicity's sake, we'll look at these three crypto-focused Metaverse projects: Decentraland, Axie Infinity, and The Sandbox.
Fortunately for data junkies, we have a surplus of data that we can aggregate across such granular time periods that it would make a career CFO's head spin. If you wanted to look at user data and compare it to day-to-day market cap, you could do that. So we do.
The charts below show the relationship between the market capitalization of a project's native token and the number of users on the platform over a one-year period.
As a general observation, I was initially surprised by a couple of things.
First, I had expected the market cap per annualized user curve to look the other way around. I had expected valuations to be inflated in the early stages of the ecosystem given sky-high valuations and low user numbers, and then to eventually decline as more users were added.
Second, the graphs of Decentraland and The Sandbox looked eerily similar (except for the user spikes in The Sandbox's graph), as if one was drawn from memory of the other. However, these two projects are seen as substitutes in some ways, like Coca-Cola and Pepsi, so perhaps this isn't all that surprising.
After all, Axie Infinity had far more users than Decentraland or The Sandbox, but its market cap per user was far lower. Granted, Axie Infinity is a money-making game, not a "decentralized metaverse," but the contrast was still striking.
Disclaimer: The answer to the question "What does this mean?" might be "nothing".
It's worth noting that this evaluation technique could be suspect, a nothing rooted in quicksand. Using a project's annual user count and comparing it to its market capitalization was an attempt to determine the value the market ascribes to each user on each platform. From there, one could look at this metric across projects and use the relative valuations to determine if a project deserves the value the market ascribes to it. This could provide a guide for comparison purposes, but there is no guarantee that it is the right guide.
This valuation technique is also subject to many assumptions. The method assumes (a) that the market knows what it is doing and (b) that these projects should have any value at all. It also does not take into account the possibility that the same people might have multiple accounts on a platform, which would overstate the number of users. Perhaps it would be more appropriate to look at transactions on the platform (which, by the way, were not significantly different from users, but at least they are unique; see below for Decentraland data per transaction). Perhaps it would have been more appropriate to look at something more nuanced that I didn't uncover.
Finally, I admit my personal skepticism about the metaverse in general. I would not call myself a metaverse believer, so it is possible that some of my biases have influenced the analysis toward more unflattering metrics. My skepticism is reinforced by the following very rough calculations and equivalencies: Twitter, an app beloved by crypto-natives, has over 200 million daily active users. Twitter's market cap is $29 billion (as of May 23, 2022). If we apply the lowest market cap per annual user in any of these charts (Axie Infinity, $118 per user), that would imply a valuation of more than $8.5 trillion for Twitter.
Call me skeptical, but that number seems pretty high to me.