How to properly analyze FDV: Do not be misled by the size of the valuation, consider the token dilution effect.
Original author: SAM ANDREW
Original translation: Deep Tide TechFlow
Full Diluted Market Cap, commonly referred to as FDMC or fully diluted value (FDV) in the cryptocurrency field, is a concept that distorts the stock market concept into cryptocurrency. The concept aims to capture the dilutive nature of protocols. However, the current way it is used has flaws and needs to be updated.
This article explores the fallacy of the concept of "full diluted market cap" in cryptocurrencies and proposes an alternative solution.
Review
Market cap represents the equity value of a company in the public market. It is equal to the stock price multiplied by the number of outstanding shares. The rise of technology companies in the 1990s gave birth to stock-based compensation systems. Companies began to pay their employees with stock options. Stock-based compensation has several benefits. It aligns incentives between the company and employees. It is a non-cash expense. It enjoys favorable tax treatment.
Until recently, stock-based compensation did not appear on the company's income statement, nor was it a cash item on the company's cash flow statement. It was an expense that did not show up anywhere. But it would eventually be reflected in the number of outstanding shares. As the number of shares increases, earnings per share will decrease under other constant conditions.
Investment analysts adjust the number of outstanding shares to account for the virtual stock-based compensation expense. Analysts add the shares that will be issued to employees in the future to the existing number of outstanding shares. The sum of the two is called fully diluted shares. Fully diluted shares multiplied by the stock price yield the fully diluted market cap. Fully diluted shares and market cap are very common in equity investments.
Application to Cryptocurrencies
A similar market cap concept also applies to cryptocurrencies. The market cap of a protocol is the token price multiplied by the number of circulating tokens. The number of circulating tokens is essentially the same as the number of outstanding shares. However, unlike the number of outstanding shares of a company, the number of circulating tokens of a protocol often increases significantly.
Companies tend to refrain from issuing new shares. Issuing shares is equivalent to selling equity in the company at the current stock price. If a company is optimistic about the future, why sell equity at today's price? Doing so would dilute the value of existing shareholders.
Protocols, on the other hand, often issue additional tokens. Token issuance is part of their "business plan". It all started with Bitcoin. Bitcoin miners ensure that transactions are correctly input into the Bitcoin blockchain. They are rewarded with bitcoins. Therefore, the Bitcoin network needs to constantly issue new bitcoins to reward the network's miners. Subsequent blockchains adopted the same pattern: issuing native blockchain tokens to reward those who accurately input transactions.
Token issuance models associated with blockchain inherently mean that more tokens will be in circulation. The market capitalization of cryptocurrencies does not capture the future circulation of tokens. Therefore, the concept of fully diluted market capitalization has been developed. Fully diluted market capitalization is the current token price multiplied by the total number of tokens to be issued. For protocols with continuously increasing token supply, data on the token supply ten years later is usually used.
Fully Diluted Market Capitalization Makes Sense to Some Extent
People rightly recognize that cryptocurrency market capitalization does not fully reflect the actual situation. Different metrics need to be used to capture the impact of all future tokens to be issued.
At the same time, the "business plan" of protocols is also evolving. The issuance of new tokens is no longer just for rewarding miners, as was the case with Bitcoin initially. Tokens are also used for network development. Token issuance can help guide the network in achieving its functionality. A network, whether it's Facebook, Uber, Twitter, or blockchain, has little utility if not many people are using it. However, few are interested in becoming early adopters. Issuing tokens to early adopters provides them with financial incentives to use and promote the network until others join and make the network itself useful.
Token issuance has also become a form of compensation for ambitious developers building protocols and the venture capital funds supporting them. There is nothing wrong with rewarding entrepreneurs, supporting venture capital funds, and early adopters. The key is that token issuance has become more complex.
But Fully Diluted Market Capitalization also has Flaws
The logic of fully diluted market capitalization has many flaws.
1. Mathematical Error
For some reason, the cryptocurrency market believes that if a protocol issues more tokens, its value should be higher. This is completely wrong. In business, economics, or the cryptocurrency field, there are no examples that show issuing more of something increases its individual value. It's a simple matter of supply and demand. If supply increases and demand is not met, the value of that thing will decrease.
FTT tokens are a typical example. Its token structure and mechanisms are similar to other tokens. Before the crash of FTX, the price of FTT was $25. The market capitalization was $3.5 billion, with 140 million tokens in circulation. The fully diluted market capitalization was $8.5 billion, with a total circulating supply of 340 million tokens.
Therefore, by issuing an additional 200 million tokens, which is an increase of 2.4 times, the market capitalization of FTT also increased by 2.4 times... How does this make any sense?
For the fully diluted market value of FTT to truly reach $8.5 billion, the additional 200 million tokens issued must be sold to buyers at the current price of $25. But that's not the case. The additional 200 million tokens issued are simply gifted away and do not generate any issuance revenue.
The table below illustrates the difference in FTT market value and token price if the 200 million FTT tokens were issued and sold instead. Token issuance simply adds 200 million tokens to the existing token supply, resulting in a fully diluted total of 340 million tokens. Token issuance has no impact on FTT market value. The expected impact is an increase of 143% in token supply and a decrease of 59% in the price of each token. This is simple mathematics. The numerator remains constant while the denominator increases, resulting in a smaller value.
Alternatively, if these 200 million FTT tokens were sold at the then-price of $25 per token, FTT would generate $5 billion in revenue, increasing its market value to the fully diluted market value of $8.5 billion. The circulating token supply would increase to 340 million tokens. Both market value and circulating token supply would increase by 143%. The end result is no change in the price of each token.
The workings of stocks are similar. If a company, like Apple, issues more shares as equity compensation to employees, it does not receive funds in return. The result is an increase in diluted outstanding shares and a decrease in price per share. If Apple were to sell shares to the market at the current price, it would receive cash in return. Its market value would increase by the corresponding amount. Diluted outstanding shares would also increase accordingly. The end result is no change in share price.
Applying the fully diluted market value logic of cryptocurrencies to stocks highlights its fallacy. If this logic holds, every company should issue more shares to increase its fully diluted market value. Clearly, this does not happen. By logical extension, every company's fully diluted market value should be infinite. There would be no limit to the number of shares a company can issue. Hence, regardless of a company's size, growth potential, profitability, and capital return rate, their fully diluted market values should be the same, i.e., infinite. However, this is clearly not the case.
So, what about deflationary protocols?
Most protocols are inflationary, meaning more tokens are issued over time. Some protocols are or will become deflationary, meaning the future circulating token supply will decrease. According to the fully diluted market value logic of cryptocurrencies, deflationary protocols would have lower future value compared to today's value.
Something that will decrease in the future would naturally decrease in value. This makes no sense. It goes against the basic economic principles of supply and demand.
2. This implies an impossible scenario
The complete diluted market value logic of cryptocurrencies implies an impossible scenario. If the fully diluted market value of FTT is 8.5 billion dollars, and the market value is 3.5 billion dollars, then the market implies that each person who receives an additional 200 million FTT tokens will create a value of $5 for each token after receiving the extra tokens. As explained, this issuance of 200 million tokens does not generate any profits. Therefore, the only way to achieve a fully diluted market value of 8.5 billion dollars is for those who receive these 200 million tokens to create a value of 5 billion dollars overnight.
But how can they do that?
How does distributing more tokens to people increase their market value? This is impossible. These tokens are likely to be stored in wallets as part of an investment portfolio. Receivers will do nothing except trade these extra tokens.
3. Unexpected Consequences
The unexpected consequence of the complete diluted market value logic of cryptocurrencies is an exaggeration of the protocol's value. Investors, whether right or wrong, often believe that the larger the market value of an asset, the higher its value and stability. Investors feel reassured by the huge fully diluted market value valuation of these protocols, but often fail to realize the logical flaws in the calculation of fully diluted market value. In this regard, FTT is the main culprit.
When the FTT price is $50, its market value is 7 billion dollars, and the fully diluted market value is 17 billion dollars. However, during that period, FTT's average daily trading volume seldom exceeded a few hundred million dollars.
The huge fully diluted market value, small market value, and minuscule trading volume are the reasons for disaster. Some tokens executed this pattern during the peak of the cryptocurrency market. This setup made market manipulation possible. The low trading volume allowed a few parties to control the volume and thus control the price. Token price determines the market value, which ultimately determines the fully diluted market value. This means that tokens that are rarely traded or involved in money laundering transactions support artificially inflated token values, with the exaggerated value being used as collateral for loans. It also masks the actual size of the investment.
Today, assets with high fully diluted market value and low market value are not as common. But they still exist. The table below lists the number of protocols that have a multiple relationship between fully diluted market value and market value.
4. Token Issuance is Becoming More Like Stock-based Compensation
Since Satoshi Nakamoto wrote the Bitcoin whitepaper, the purpose of token issuance has undergone significant changes. Issuance is used for various purposes other than rewarding network miners and validators.
Token issuance is increasingly resembling equity compensation in the cryptocurrency market. The protocol rewards those involved in building the network with native tokens, much like a company rewards employees, advisors, and investors with stock options for contributing to the company's development.
Token issuance should be seen as similar to equity-based compensation. Issuing tokens, like issuing shares, is a cost to the protocol or company. It dilutes the number of circulating tokens or shares. However, if done correctly, this cost is an investment. It generates returns. Stock options granted to a dedicated employee can create value for the company that exceeds the value of the granted stock. Similarly, network participants can create value for the protocol that exceeds the value of the granted tokens.
The returns generated from granted stock or tokens may not be known for a long time. Before that, a well-thought-out stock or token grant plan is the best guide and can foreshadow possible outcomes: an excessive distribution of tokens or severe dilution with no value.
Not all token distributions are equal
The fully diluted market cap includes all future token issuances. However, not all token issuances are the same. Some tokens are distributed to early adopters, some to the founding team, and some to early investors. Some tokens are allocated to the protocol's foundation for future use. These include tokens allocated to reserves and ecosystem funds. They are tokens intended for the development of the network. Tokens intended for future investment in the network should not be included in the circulating token supply.
Tokens allocated for future investment are equivalent to cash on a company's balance sheet. Cash on the balance sheet decreases the total value of the company. The total value of the company is its enterprise value. The enterprise value reflects the value of all the company's assets. Part of the enterprise value is the equity value of the company. For publicly traded companies, equity value is its market capitalization. Another part is net debt. Net debt is total debt minus cash. This concept is how the company's total assets are funded by equity and net debt. The table below shows how increasing cash reduces the enterprise value of the company, assuming all other conditions are the same.
The value of tokens designated for investment is equal to the token price multiplied by the specified token quantity. This represents the capital that the protocol must invest. It is equivalent to cash on the balance sheet.
The following table mechanically outlines this logic. The example in the table outlines a protocol with 500 circulating tokens. An additional 200 tokens are issued to reserves. These 200 tokens are designated for investment in the network. With a token price of $5, the market capitalization and fully diluted market capitalization are $2,500 and $3,500, respectively. The value of the 200 tokens designated for investment in the reserves is $1,000. This $1,000 value should decrease the total value of the protocol, just as cash reduces the enterprise value of a company.
Tokens for future investments can be seen as the company's unissued shares. The conclusion is the same as treating them as "cash". The future shares that Apple may issue are not included in its fully diluted market value. Apple can sell shares for cash income. This cash can be used to develop Apple products. The future value of these products will ultimately be reflected in Apple's market value. Similarly, protocols can issue tokens to their treasuries in order to obtain "cash" income for investing in their networks. The difference is that for protocols, "cash" is their native tokens. It doesn't actually need to sell shares to the market like Apple to earn income. In this case, the protocol is more like the Federal Reserve, which issues more currency to pay for expenses.
The difference lies in flexibility
The reason why protocols have so many tokens in circulation from the beginning is because their structure is very strict. Companies can freely issue and repurchase shares but need approval from the board of directors and final shareholders. In contrast, protocols try to make issuing and destroying tokens much easier.
From the beginning, protocols need to determine how many total tokens will be issued and when. It's a mentality of "everything is determined on the first day". Companies and the Federal Reserve don't operate with this level of strictness. The number of company shares and the amount of US dollars in circulation fluctuate according to market dynamics. Protocols need to disclose a certain number of tokens because their tokens are used as currency value to reward network participants. If the token quantity is uncertain, participants will worry that the currency value they receive will be devalued due to token inflation. The cost of eliminating this concern is an inflexible token structure.
Overhyped Fully Diluted Market Cap (FDMC)
Some protocols overhype their Fully Diluted Market Cap (FDMC). The token quantity used to calculate FDMC includes tokens issued to the protocol treasury for investment. The inflated token circulation quantity results in an overhyped FDMC. This further leads to higher valuation multiples.
For example, Arbitrum and Optimism overhype their FDMC. Their FDMC includes the total token quantity to be eventually issued. However, in both cases, a large number of tokens are issued to the finance department or equivalent department. These tokens are designated for investment in the ecosystem. By removing these tokens from the total token circulation, a more accurate adjusted token supply can be obtained, thus obtaining an adjusted market value.
The table below illustrates the adjustments made to the token circulation of Arbitrum and Optimism. The adjusted token supply is 45% lower than the fully diluted figure.
So what is the correct token supply?
The circulating supply is correct to some extent. It reflects the current number of tokens issued. But it ignores the impact of future token issuance. The fully diluted supply is also correct to some extent. It reflects the eventual number of tokens to be issued. However, it fails to adjust for tokens issued to the treasury. The adjusted figure should be based on the fully diluted number and deduct the tokens issued to the treasury.
One thing is certain, the fully diluted market cap figure can be misleading. Astute analysts should not exaggerate the protocol's market cap based on future token issuance, but rather attenuate existing valuations by factoring in the dilutive effects of future issuance.
