- The shift in ethereum from proof-of-work to proof-of-stake will take place in the second quarter of the year.
- This change will enable investment analysts to use discounted cash flow (DCF) to value ether.
- We break down how one analyst sees ether’s upside ranging from 90% to 220% by using DCF.
Ethereum’s transition from a proof-of-work to a proof-of-stake consensus mechanism is set to bring many exciting developments to the network including reduced energy usage, cheaper gas fees and faster transaction speeds.
One lesser known benefit, however, is that investment analysts will now be able to use their trusted cash flow analysis methods to value ether, the second-most traded cryptocurrency.
In Bloomberg Intelligence’s most recent crypto outlook note, their strategists explain how the switch to proof-of-stake will make it easier to build valuation measures for the ethereum network.
“Discounted cash flow (DCF) analysis shows ethereum may be undervalued as it approaches an upgrade,” said Mike McGlone, Bloomberg Intelligence’s senior commodity strategist, in the April note.
In a proof-of-stake model, individuals contribute their own crypto to validate transactions and when the blockchain is updated with the data they earn a reward in return.
“Traditional investors may discover the rules of the game have changed with ethereum, which is developing into a crossover asset with a unique blend of equity, commodity and monetary characteristics,” McGlone said.
The next step in that process is “the merge”, which is expected to take place in the second quarter of this year.
The merge
The “merge” will be “a blink and you miss it event”, according to Simon Morris, the head of strategy at ConsenSys, the blockchain technology company founded by Joseph Lubin, the co-founder of ethereum.
The event is simply a switchover where the block production will be redirected from one source to another, said Morris in a recent interview. After the switch, ethereum will then start using a proof-of-stake consensus mechanism and rely on the Beacon Chain, which has already been in production for over a year, he added.
“The upcoming merge, shifting ethereum from a proof-of-work model to proof-of-stake, will convert ether into an equity-like instrument with elegant supply/demand dynamics that could drive significant interest in the asset,” McGlone said.
Individuals who choose to stake ether to help validate the blockchain will be entitled to share of the revenue generated on the network.
Around 70% of the fees will be burned, which is akin to a buyback, while the rest will be distributed as a reward, or dividend, to the stakers, according to McGlone.
“If demand for blockspace and total fees paid increases, stakers will enjoy both higher payouts and reduced issuance, with the opposite also true,” McGlone said.
“Blockchains have no direct costs (only indirect, in the form of token issuance) so revenue represents the bottom line (profit), allowing the use of traditional financial ratios such as P/E multiples,” he added.
A cash flow valuation determines the value of money over different periods. Discounted cash flow is the best-known and estimates the value of an investment based on its expected future cash flows.
The change in the consensus mechanism now allows for similar methods to be applied in valuing ethereum.
Ether cash flow analysis
In the report, the strategists use three different discounted cash flow analysis methods to come up with a valuation range for ethereum.
They use both base and priority transactions fees in their cash flow estimates. However, they exclude the staking rewards that come from transaction fees, or new issuance and also exclude any deflationary burn from the EIP-1559 buyback that should occur once the merge is complete.
The core scenario is the perpetuity growth method, which assumes the growth rate of free cash flows in the final year of the first forecast period will continue indefinitely. Using this method, ether has a value of $6,128, compared to its current level of around $3,300.
The second, and more conservative estimate, comes from using the “H-model”, which finds ether’s value to be $5,539, 90% higher than it was when the report was published.
The final approach is the use of a price-to-earnings exit method, which estimates cash flows using a series of multiples. Based on an exit multiple of 25 times, similar to that of Apple, ether should be valued at $9,328, about 220% higher than where it is right now. And considering that ethereum has a higher growth profile than Apple, this multiple is conservative.
“Triangulation of the three DCF methods provides an average value of $6,998, 140% higher than current levels,” McGlone said.
However, delays with the merge could have an impact on how much that changes the price. In particular, McGlone says the main risk to revaluation would be sub-par aggregate transaction fees.
ConsenSys’s Morris said the merge alone won’t mean the ethereum blockchain can suddenly accommodate all new use of the network.
“The merge is not going to introduce scalability, it’s going to introduce the preconditions from which you can scale but in and of itself, it’s not going to introduce scalability,” Morris said in a recent interview.
The bull market trend
The Bloomberg Intelligence team believe the structural trend towards decentralized finance, social experiences and gaming should underpin a strong period of growth for ethereum, which should lead to a higher price over the next 12 months.
“The network is on track to generate $12.7 billion in 2022, and our base model projects a 30% annual rise in cash flow over the next three years (vs. the 212% trend) before decay to a terminal growth rate in 2035,” McGlone said
“As visibility improves on the merge in coming months, ethereum may close the valuation gap, potentially outperforming other assets in 2022,” he added.
One encouraging sign is the strong rally in altcoins in the past month. A number of them, including solana, terra and avalanche, posted returns in March that were 1.5 to 2 times higher than bitcoin, even taking
volatility
into account, according to the report.
“This improvement in technical breadth is a healthy sign that risk appetite is returning,” McGlone said.
