Tangible value in a digital world

The world “Tangible” finds its roots in the Latin verb “tangere”, which means to touch. And when it comes to assets, the line between how tangible and intangible assets are treated is a rather arbitrary one. We won’t go down the black hole of accounting rules, but it would suffice to say that the treatment of intangible assets is given much less attention than tangible ones. This is largely a legacy issue as the accounting rules were formalised in a different time.

That made sense in a world of physical buildings, plant equipment or physical assets. But what about a world of digital rocks, penguins, apes and punks, many of which have been grabbing recent news headlines for trading at supposedly ridiculous prices? What about a world where there is a burgeoning digital metaverse, in which people around the world are making a real living by undertaking activity in that realm?

In a way, this movement of value (whether we agree with it is irrelevant) was unavoidable in the march from the physical to the digital. Yes, there is still huge amounts of physical infrastructure and assets to be constructed, especially in less developed regions of the world. But to assume that all things follow the same path of development is a dangerous fallacy. Latecomers benefit from the infrastructure laid down by the early movers and leapfrog development, which suggests that on balance, there is going to be much more digital infrastructure (and assets) to be constructed in the future.

This opens up an interesting rabbit hole to dig into: in a world where the balance of physical vs digital assets is skewing in favour of the latter, how do we think about capital efficiency when all it takes to build a potentially world-dominating protocol is lines of code?

This isn’t a concept that is completely new: the rise of internet giants like Facebook, Netflix and Google, and the likes of Microsoft before it, have set the stage. Yet even now we struggle to pin down value for intangible aspects of those businesses like content, user reach, brand value and network effects. Metrics like EV/User and cost per click were made up as tools to compare valuations between internet companies where prior P/E, EV/EBITDA and P/B ratios failed to capture the growth opportunity.

In a way, the imperfections of these “new” metrics get glossed over because these internet giants are now big enough to operate on a P/E basis, albeit at a different range of values from traditional businesses. Analysts literally faked it till their companies made it and avoided dealing with the gaping holes in those methodologies.

Now, when almost every new company is going down that same route, those shortcomings are being laid bare. Add to the mix a decentralised web where the owners are also the users and the developers, where the metaverse is being constructed from multiple different angles and where an entire economy is flourishing outside the bounds of the physical and valuing these intangible worlds (with nonetheless highly tangible outcomes) gets even more challenging.

It’s more than “just a game”.

All you need is code

Iron Monger: You had a great idea, Tony, but my suit is more advanced in every way!
Iron Man: How'd you solve the icing problem?
Iron Monger: ... Icing problem?
[Iron Monger's systems short out from the cold, sending him plummeting to earth]
Iron Man: Might want to look into it.
- Iron Man (2008)

h/t to Dan McMurtrie for a reminder of this awesome quote from Iron Man in this exact context of valuations.

There is an immense body of financial orthodoxy that deals with valuations, including lines of established wisdom like the value of shareholders’ equity being “the present value of all the future cashflows accruing to shareholders”. The problem is few realise this is just another meme, hidden within a wrapper of mathematics, designed to give its wielders a certain degree of confidence.

Indeed, even the idea of P/E, P/B and EV/EBITDA as indicators of fair value is a meme, as eloquently explained by the pseudonymous DegenSpartan in this post. Yes, as argued by his partner CL, even revenue as a basis for valuation is a meme.

The incapability of this orthodoxy when it comes to valuing the intangible becomes even more pronounced when it comes to software, networks and most recently, the economies built in the decentralised web of crypto. Relying on this orthodoxy is where the danger lies.

We’ve already seen, in the example of movements like Decentralised Finance, the power of code deployed on the decentralised web – the yield aggregator Yearn (our note on it here) was built by a single developer and went on to garner north of US$1bn in total value locked just weeks after its initial launch (that number is now just over US$4bn). Its biggest competitor, Convex, launched in May 2021, just 3 months ago, and since then it’s picked up US$6bn of value locked, eclipsing its predecessor, again built purely on code deployed on Ethereum.

The result of a code-only business, operating under the auspices of a DAO (our note introducing DAOs here), with no physical office, address or infrastructure, is that these protocols run with mind-blowing capital efficiency. Uniswap, the largest decentralised exchange around, reportedly has approximately 38 employees – 33x fewer personnel than centralised exchange Coinbase, while trading 77% of Coinbase’s trading volume.

Calculating capital efficiency metrics like ROIC or ROCE would be easy – simply a case of jabbing numbers into a calculator. But making sense of them in comparison to traditional industries (e.g. a stock exchange, or even a centralised competitor like Coinbase) isn’t going to be straightforward. How would a business that generates real cashflows from something as intangible as code be evaluated, especially when the initial code is the equally intangible intellectual property of the founders?

Venturing into the metaverse requires even more consideration. Before even getting into the realms of decentralised metaverses like Decentraland and Axie Infinity, let’s consider something like Roblox. For those unfamiliar with its inner workings, Roblox is by far the closest listed equivalent of a “play to earn” environment, comparable to Axie Infinity in the sense that developers (rather than players) can build experiences within the Roblox multiverse, which they subsequently monetise when users come and spend Robux, the native currency of the world of Roblox, within the mini worlds they create.

Roblox itself is a vendor of digital goods within this world and applies a well-defined revenue recognition policy when it comes to recognising revenue from the sales of digital items. But what about the fact that the environment itself is an asset, a flywheel between critical mass of users attracting developers who make engaging experiences which then attract users which attract developers…

And within that world, what about the content that is being created within? Is it worth as much as content that exists outside in the “real” world? When Netflix’s Stranger Things runs an experience in Roblox which involves players surviving and escaping as a team, does the content within Roblox reflexively influence the value of the Stranger Things franchise for Netflix, or vice versa, or both? That Roblox’s management team, faced with varying interpretations of their numbers by different analysts, had to spend time clarifying in very simple terms how ratios of metrics work on their most recent results call (as well as in their shareholder letter) reveals how little consensus there is around a methodology for valuing such a business.

And finally, going back to the idea of insanely priced pixelated JPEGs of apes, rocks and penguins – how much would it be worth to be able to display these items, confident in their verifiable uniqueness, in a virtual realm in which arguably “real” business generating “real” cashflows operate?

Whether in Roblox, Axie Infinity or any other multiverse that comes to exist, decentralised or centralised alike, there is going to be infrastructure that is put in place which is arguably fully digital – how much is that digital infrastructure worth? And if it was all coded with little monetary cost, how would the returns on intellectual property be calculated and valued?

Code continues to eat the world

The capital efficiency of code deployment is arguably something that is unmatched by anything in the physical world, limited only by bandwidth and computing capacity which, for the moment, appears to still be in ample supply. It is this scalability, along with the unfettered ability of the internet to distribute content and value instantaneously across the globe, which turns the decentralised web into a borderless world.

Most importantly, the lack of high capital costs as a barrier to entry changes the dynamics of microeconomics profoundly. Economies of scale matter more than ever, since with no significant cost barriers in play, the race for critical mass in terms of the size of each project’s user community is of paramount importance. Once attained, the challenge is to keep growing, because failing to grow is tantamount to failure – constantly outgrowing the competition is the only way to stay ahead in a world of open-sourced code.

Fortunately, there is abundant growth ahead for the foreseeable future, with the scope for disruption, especially of legacy business models, continues to grow as the capabilities of the decentralised world, powered by token economics, accelerate almost exponentially.

As investors in both the traditional world of equities as well as this emerging realm of crypto assets, we see this as nothing more than a natural progression from the old to the new. Code will continue to eat the world, and just as e-commerce took traditional retail out in the “bricks to clicks” narrative, so too can we expect disruption to come in the most unimaginable ways from the world of crypto to the “real” world as we know it.

Eventually, reality will evolve too.

Although this time, Wall Street’s analysts may not be in as much luck as they were before, because where the titans of the internet age at least shared a similar capital structure with traditional businesses, operating for the benefit of shareholders, the giants of the decentralised age operate on a completely different frequency and philosophy.

As a result, anchoring valuations back to the realm of the familiar becomes ever more challenging. Without the “floor value” of these projects being rooted in supposedly tangible balance sheet items like PPE, everyone has to start thinking properly about how to work out the value which the network, the users and the intellectual property brings to the opportunities for future growth.

All this, while avoiding the trap of falling into a meme echo chamber once a familiar anchor is found: does it really matter that Axie Inifinity’s daily revenues post a slight dip, when they are now one of the best-funded games in the decentralised world, with one of the strongest and largest gamer communities around, while still churning out anything from US$10-12m/day of revenues?

Or that Roblox’s monetisation ratio metrics like Bookings/User show a dip, despite both bookings and active user count growing, while their user mix steadily becomes more and more diverse and lucrative?

Code continues to eat the world like never before, so why are we still adopting mental models of valuation prescribed by our predecessors who operated in a world that’s so different from what it is now?

If you don’t see the meme, you’re in the meme.

What does it mean to be tangible?

Many will remember the now-famous quote that came from this TechCrunch article by Tom Goodwin, The Battle is for the Customer Interface:

Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening.

The era of the centralised platform provider set the stage for what is happening today, breaking old habits and bringing users into the realm of online interactions. Just as Uber normalised the idea of riding in someone else’s car, and Airbnb normalised the idea of living in someone else’s house, effectively sowing the seeds for the notion of a decentralised taxi provider or hotel chain.

Businesses sprouted up around these platforms, from cleaning and property management services that supported Airbnb landlords to fleet rental services that catered purely to Uber drivers.

Are these platforms and the businesses that revolve around it tangible? It wasn’t clear in the beginning, especially where profit margins were thin or even negative, that some code and a website was worth much. But over time, these have become not only indispensable in daily life, but they have also fundamentally changed the way we think about ownership and value creation.

Just as the notion of living in someone else’s spare room or hitching a ride from a stranger in their car sounded absolutely ludicrous to start, so too is the notion of operating a business and making a living in a digital universe, in which players undertake some sort of activity which other players are willing to pay for.

And if someone makes a living in a virtual world and gets paid in a currency which can be converted into cold, hard cash, are the tools, assets and “real estate” in that virtual world tangible and real? Fungibility of digital assets into cash, in a borderless world with near-infinite scalability built on code – what more could a digital entrepreneur ask for?

At the end of the day, as long as that effort translates into cash, does it matter at all whether the assets exist in pixels or in a physical form? We’re not saying that it makes sense that digital rocks are valued in the millions, but the question is – does it need to make any sense at all?

Welcome to the very tangible world of the intangible.

Eugene Lim