"A great business at a fair price is superior to a fair business at a great price."
— Charlie Munger
Great vs. Fair
There’s a famous trick that M&A bankers play when they get into the last decade or so of their career.
If they’ve been working on a big deal and feel like they’ve got it pretty much in the bag, they quit their investment bank and set up shop as an independent M&A advisor. So when the deal is signed, they collect the entire fee for themselves.
This is why you will occasionally see a large M&A deal advised by a tiny new M&A shop. The customer doesn’t have a relationship with the bank, it has a relationship with the banker.
When the banker leaves, the business leaves with them.
As the saying goes, a bank’s best assets leave every night, by the elevator.
And sometimes they don’t come back.
It’s for this reason that investment banks have historically been lousy for shareholders.
Investment bankers are plug-and-play. A bank can hire an entire team from a competitor and know that the team will bring all of their customers with them.
It’s the TradFi version of a vampire attack.
Banks have to pay most of their revenue out in bonuses in order to prevent those attacks. Which generally leaves not much to be paid out to shareholders.
This is why Goldman Sachs, the best investment bank of all time, currently trades on a price-to-earnings ratio of 6.
Keep that number in mind for the next time you’re told that a DeFi token is “cheap” — which is something I’ve been hearing a lot lately.
Light on Their Assets
Investment banks are probably not the best comp for DeFi tokens, however, because they do have some assets that do not walk out the door every night: brand names, proprietary algorithms, clearing relationships, etc.
DeFi protocols, in contrast, are just a bundle of smart contracts.
In this, they are less like investment banks and more like an asset-light shipping company.
Take, for example, ZIM Integrated Shipping, a current favorite on FinTwit.
ZIM is an asset-light cargo shipper. It charters container space from large shipping companies and then contracts that space out to its customers.
Its business, therefore, is a set of contracts.
And its revenue is the pricing differential it captures between those contracts.
It’s not so different from a DeFi protocol in that sense — ZIM is essentially a set of shipping contracts and DeFi protocols are simply a set of smart contracts.
Being an asset-light bundle of contracts can be a good business, as ZIM’s healthy results are currently demonstrating.
But investors are not so keen: ZIM trades on a price-to-earnings ratio of 2.5.
Lots of people on FinTwit think that’s too low, but even the biggest ZIM bulls would tell you a fair valuation would be maybe 5x earnings.
Because when your business is to capture a spread between contracts, your profitability is a function of two things you have little control over. In this case, it’s the cost incurred from leasing containers vs. the revenue received by hiring them out.
Further, these spread-based businesses generally do not accrue value over time: There is no asset base to invest in, so profits get paid out in full to investors.
So future profitability is strictly a function of the fluctuating market prices for each of those contracts. Not, as is the case with most equities, an asset that naturally becomes more valuable over time.
Investors prefer profitability derived from assets.
Mortgage REITs get a similarly low multiple for the same reasons. Their business is simply to borrow on short term contracts and lend on long-term contracts. If the prices of those two contracts converge, they no longer have a business.
The biggest mortgage REIT, Annaly Capital Management, trades on 4x earnings.
Protocols Are Contracts
Smart contracts are not legal contracts. But for investment purposes, they might as well be.
The value of a protocol can change suddenly if its smart contracts get forked. Or if the protocol gets vampire attacked. Or if it loses customers to an aggregator.
And, as with contract shippers and mortgage REITs, protocols tend to have little or no value accrue over time.
There are exceptions: Uniswap has been adding tokens to its treasury and reinvesting profits into the development of its V3 offering, which has been a hit.
But, for the most part, protocols are like shippers and REITs in that they pay all (or more) of their earnings out to token stakers.
It would be difficult to reinvest even if they wanted to. The incentives in crypto are such that developers stand to make far more working on a new dApp than improving an existing one.
Why take a salary to make an incremental improvement to an existing protocol when you can fork the protocol and get equity in a new, improved protocol for the same amount of work?
Given the chronic shortage of developers, that dynamic alone could shape the space for many years to come.
Fairly Great Prices?
The bottom line is that not every bottom line is created equal: Earnings derived from assets get a higher valuation multiple than earnings derived from contracts.
Which means that DeFi tokens should be valued like investment banks, shippers or mortgage REITs — all the things that get the lowest multiples in TradFi.
So the next time you hear that DeFi tokens are “too cheap,” make sure you are using the right TradFi comps in your mental model.
Yearn’s 13% yield is not so extraordinary when you compare it to ZIM’s 14% yield.
And SpookySwap, the cheapest crypto according to Tokenterminal.com, is not any cheaper than Goldman Sachs.
After a long run of underperformance, DeFi tokens may be trading at great prices. But they are still only fair businesses.
As per Charlie Munger, investors should consider looking to invest the other way around.
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