Dividend paying cryptocurrencies are becoming a dominant, emerging trend. Crypto-investors should be aware of their dynamic, and how they can enhance returns. Given their similarity with dividend-paying stocks, we can look at historical data and models from the stock market to try and make predictions on how the dividend paying cryptocurrencies will or could evolve over time.
Dividends vs. Proof of Stake Rewards
Before we proceed further, I want to clarify that proof of stake rewards do not qualify as dividends. Dividends are paid via economic profits, whereas proof of stake rewards are paid via inflation. These should not be confused. In order to pay dividends, the cryptocurrency needs to provide some economic benefit, and use those proceeds to pay dividends to the token holders. Remember – earnings, not inflation.
Some proof of stake cryptocurrencies will pretend or mislead investors, and call their stake rewards dividends. Please don’t fall for that. In this article, we’ll strictly discuss ‘real’ dividends, i.e. earnings created in the ecosystem, and not ‘fake’ dividends paid out via inflation of the monetary base.
A Brief History of Dividend Paying Cryptocurrencies
To be sure, the idea of cryptocurrencies paying dividends is not new. However, the idea has evolved over time, and so have the implementations.
The first time the idea was seriously used in a cryptocurrency system that I am aware of was in Bitshares (if it weren’t for the founder’s greed, it could today have been a great system). Bitshares originally was a decentralized asset trading platform that traded market-backed assets, with game-theoretic price convergence between the Bitshares-assets and real-world assets.
Bitshares’ original idea and implementation was that the entire ecosystem would take a fee for trades that occur on its platform, say, BitBTC/BitUSD trades. This fees is then returned to all the BTS holders. This original implementation didn’t increase the supply of BTS to the holders while keeping supply constant. Rather, due to programmatic ease, it just decreased the overall BTS supply, in effect making each BTS a little more valuable.
This is more like a stock-buyback rather than a dividend. Economists would argue they are the same thing, but psychologists should know better. The Bitshares idea never took off, and the dividends were limited anyway. Add in a later inflation schedule, and the supply increased way more than any economic benefit to the system, thereby rendering the whole idea invalid.
DigixDAO was the first Ethereum-based token that started paying dividends. Note that this dividend is paid from earnings, not inflation. The earnings model comes from gold storage – the Digix Gold Tokens (DGX) are asset-backed Ethereum tokens (gold-backend) that freely trade in the market and can be transferred via the Ethereum network to Ethereum addresses. This generates fees – usage and storage fees. This fees, in the form of earnings of the DigixDAO, is distributed to the holders of DigixDAO, the DGD tokenholders.
Note that unlike Bitshares, DigixDAO has a full backing of gold in its valut. This naturally also requires costs to maintain, insurance, audits, etc.
After the launch of Ethereum and its use as a serious cryptocurrency platform, there was a renewed interest in systems built on top of Ethereum that had real economic benefit. Many projects chose to provide that economic benefit in the form of dividends to the holders of the tokens.
The first large-scale Ethereum project to implement this idea was Augur. Augur is a decentralized prediction marketplace where REP (reputation) tokenholders report on all the events created in the system. To provide incentives for them to report (and report correctly), they are given a certain fee from all the markets.
This economic system in Augur is quite clear. REP tokenholders get rewarded based on the total economic activity occurring in the Augur system. The more people use Augur to place bets and trade them, the more the REP holders get paid. The payment to REP holders is clearly from the economic benefits provided by the system, not via inflation. Note that Augur differs from some other Ethereum-based tokens in that there is no ‘central’ party that generates earnings (centralized gold storage in Digix, the ICONOMI team in ICONOMI, the Singular team in SingularDTV, etc.) and the system is completely decentralized – there is no one party that holds power over the system.
Note that Augur as a token has launched, but the full platform is still in Alpha and hasn’t launched yet. It would be a great case study for dividend paying cryptocurrencies when it launches.
Many projects followed Augur that provide dividends from the economic activity being created. Here are some of these Ethereum-backed tokens:
- ICONOMI (ICN) – it is a crypto fund-management platform that will create and trade an index-fund like token and a hedge-fund like token. The future plans also include a fund management system open to all investors and traders. The more popular these funds become, the more dividends ICN tokenholders get.
- SingularDTV (SNGLS) – it is a digital rights management platform combined with original content. The original content includes a documentary and a mini-series. The more revenue the original content production gets, the more dividends get paid out to SNGLS holders. Also, the more their digital rights management platform gets used by artists, the more the payout to SNGLS holders.
Let’s discuss some of the basic terminology required to analyze dividend paying cryptocurrencies. These are similar to the corresponding terminology used for the valuation of other financial instruments, like stocks.
- Revenue: This is the total amount of money brought in via sales of goods and services by the ecosystem. Examples of services include Augur, which provides the service of a decentralized prediction marketplace. Examples of goods include Nodio (not active anymore), which provides a home router with additional security layers built in.
- Cost of Goods and Services (COGS): This is the money spent to acquire the revenue. We do not include any prior costs, such as running a foundation/organization that is responsible for creating the software product and other marketing costs. These are paid out through the ICO funds. We are interested only in the costs associated with providing the service. Some systems, like Augur, have a zero cost. Some others, like ICONOMI, have a variable cost that is determined at the discretion of the founding team.
- Earnings: This is simply the difference between revenue and COGS. Earnings = Revenue – COGS. Earnings is the profits generated by the ecosystem.
- Retained Earnings: This is the money that is earmarked to grow the ecosystem further. If a project has a positive net present value (NPV) (for simple cases, if the internal rate of return (IRR) is more than the cost of funds), then retained earnings can be used to take that project up, and hopefully it has a net positive impact on ‘shareholder’ value. Different projects handle this differently. Augur, for instance, has no retained earnings. SingularDTV has a fixed 40% retained earnings.
- Dividends: This is the ultimate cash flow to the ‘shareholders’. It is the money distributed after removing retained earnings from the earnings, i.e. Dividends = Earnings – Retained Earnings. Ethereum based projects so far seem to prefer to distribute dividends in the form of Ether.
- Buybacks: Buybacks refers to using the free cash flow to buy and burn some of the tokens, instead of paying it out in the form of dividends. As far as I know, none of the projects are using any earnings for the purposes of a buyback. However, Bitshares implemented such a system, which however isn’t very visible due to later introduction of inflation. I suspect some projects in the future might opt for buybacks in addition to dividends.
For the first time for crypto investors, it is possible to create a valuation model for these cryptocurrencies. That’s right, the dividend paying cryptocurrencies should be driven more by the underlying economics and less by speculation. Therefore, I expect the volatility to be lower than regular cryptocurrencies. Also, I expect their behavior to be similar to stocks in the stock markets. This is a good thing, because we can now use methodologies and analysis that works in the stock market already.
Before we proceed though, please note that valuing any cryptocurrency, even Bitcoin, is going be a very difficult task because the value is driven more by supply and demand and speculation than any income-earning potential. There is bound to be a fair element of speculation even within these types of cryptocurrencies.
Price-to-Earnings Ratio (PE Ratio)
The PE ratio makes the most sense out of all the other ratios, like price to sales, although you should keep an eye on those as well. The PE ratio that would determine the fair value of the token should take future growth into consideration. If the expected growth is high, the ratio will be higher, and the price of the token will also be higher. the expectation is that the future dividends from this dividend paying cryptocurrency will be higher than they are now, and grow at a rapid rate.
You should also take special events into consideration. Take Augur for instance. The market will likely grow with time, and you get a ‘stable’ PE ratio based on that growth. However, there will be other growth spurts, like in 2020 presidential elections, with the markets likely starting to take hold around 2019 already. Then there are major sporting events, like the soccer world cup globally, or US based events like the super bowl that will likely attract a lot of betting. In terms of growth, you should take organic growth in existing markets, like politics and sports, but also opening up of new markets, like financial CFDs or esports.
Note that assigning a PE ratio assumes a going concern for the ecosystem, i.e. it will last indefinitely. If you don’t believe this to be true, discount your analysis accordingly.
Dividend Discount Models
In cases where the dividend is easy to estimate as a percentage of earnings, you can apply dividend discount models to value these dividend paying tokens. One advantage of this method over PE ratio is you can split this up into components with different growth rates, and calculate the value accordingly. You also have more flexibility in terms of assigning a terminal value, after a given period, to make it aggressive or conservative.
The Gordon Growth Model is the simplest type of dividend discount model that you can use. It assumes a single growth rate and rate of return. This is usually too simple, so you can apply one of the multi-stage dividend discount models as well. Ultimately, you can tweak and play around with the number of growth stages, assumptions of growth, and terminal value calculations.
The biggest challenge is trying to calculate the required rate of return. This is an almost impossible task for cryptocurrencies. Your assumptions here will greatly affect the final outcome of the valuation.
The stock-like characteristics of dividend paying cryptocurrencies allow us to use some of the models used to value stocks. This helps provide a benchmark valuation model. Depending on the valuation obtained from the model, and the price determined in the free-market exchanges, an investor can make a decision whether to invest in this cryptocurrency or not, or what the fair value is. Combined with a margin of safety, the fair value estimation will determine whether the investor would buy or sell, or just stay put without taking any position. However, speculation can also play a role, like with any other cryptocurrencies.
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