COINBASE: Great Business Trading 18% From Fair Value
Coinbase full Discounted Cash Flow valuation and Monte Carlo simulation.
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DISCLAIMER: The publication expresses my own opinions. Information presented is for educational purposes ONLY and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.
Introduction
Coinbase will soon be forced to switch its focus from the highly volatile and profitable retail business to the institutional investors' stable and low margin revenue flow.
At the moment, Coinbase's main revenue driver is the retail interest in cryptocurrencies driven by the recent exponential Bitcoin’s growth. The faster it grows, the greater the number of retails joining and trading on Coinbase. This relationship is demonstrated by the high correlation between the revenue generated and Bitcoin’s price.
Although cryptocurrencies are here to stay, I don’t expect them to keep growing at this rate for much longer. Bitcoin and Ethereum already have a market capitalization higher than several big companies in the United States, like Coca Cola or Verizon. In addition, the more cryptocurrencies get accepted as a mean of exchange, the more their volatility will converge towards that of any other fiat currencies.
When the growth rate will slow down, and the price will start to move like a normal boring asset class, the retail traders will leave Coinbase and start chasing the next get-rich-quick scheme. At this point, Coinbase will need to entirely focus on becoming appealing to the institutional investors who, in the meantime, are slowly accepting the cryptocurrencies as a new asset class to diversify their portfolio.
To acquire and retain the institutional investors as clients, Coinbase won’t be able to use the current “Discover new cryptos and earn 30$”, but they will be forced to heavily invest in costly new licences, bigger compliance and sales department, trade reporting, liquidity and security.
Obviously, they also won’t charge the high commissions they are charging now, and their margins will lower towards the industry mean. The trend is clearly visible in the chart below.
I believe Coinbase is well-positioned to become an important crypto exchange and will be able to compete with other big players that will try to enter the segment. Being the first Crypto Exchange to be listed on a stock exchange, Coinbase increased its trust and brand awareness and got access to cheaper capital to fund its R&D and expansions plans. In addition, they have been cultivating compliance and regulator relationship. According to Bloomberg intelligence:
“Coinbase is among a shortlist of U.S. cryptocurrency operators holding New York State's Virtual. Currency License -- BitLicense -- giving it an edge over non-U.S. participants and a barrier to entry for crypto startups.”
If Coinbase succeeds in being widely regulated in multiple jurisdictions, it will create a small moat around its business operations thanks to the upfront cost the competitors will need to face to get the licences and start operating.
How much is Coinbase worth?
Coinbase’s reported revenues and earnings are not directly representative of the underlying business because, as mentioned early, the price of Bitcoin highly influences every figure shown in the income statement.
The impressive Bitcoin’s performance during the past year highly inflated Coinbase’s revenues and earnings. Consequently, the figures shown in the most recent reports are not representative of the underlying business growth but just a consequence of the cryptocurrencies’ growing prices.
The relation is similar to that of oil companies and the oil’s price. If the price of oil doubles, does it mean that the company has now doubled its size? Not really. The same is happening with Coinbase.
To normalize the revenues figure, I used the line of best fit shown in figure 1. It shows that Coinbase’s revenues increase by $ 46.2m for every 1000$ increase in Bitcoin price. Using the regression results and the mean value of Bitcoin for the past 2 years of $15,500, I get a normalized revenue of $ 878.12m.
I also adjusted the operating incomes by reclassifying R&D as CAPEX with a 1-year life. This helps to understand better the actual ROIC and Reinvestment rate, which later will be used to estimate the growth rate. Using the same regressions process, I get an operating income of $ 501.46m.
By combining a forward ROIC of around 30% with a 60% reinvestment rate, I get an expected 35% growth rate for the next 5 years. Please keep in mind that this is the growth of the underlying business. The actual revenues will fluctuate around this value depending on the cryptocurrencies’ market capitalization.
I expect the adjusted margins, net of any R&D expenditure, to stay around 50%. The tax rate will converge towards 25%, and the cost of capital will lower from 7.72% towards 4.40% in the terminal year.
The resulting cash flow is shown in figure 3:
By summing the present value of all future cash flows, adding cash and subtracting debt, I get an enterprise value of around $ 50bn. However, before dividing this value by the number of shares, it’s worth noting that Coinbase has 63 million outstanding stock options with an intrinsic value of $ 11bn, which needs to be subtracted. The value is this high because Coinbase is using its shares to pay for acquisitions and stock-based compensation, which, in the future, they will turn into cash expenses.
The fair value I get for Coinbase is $184, 18% lower than the current price of $ 244 at the time of writing.
Coinbase Monte Carlo simulation
To consider the Bitcoin price variance and the uncertainty around the future growth rate, I did a Monte Carlo simulation.
Instead of using the Bitcoin price of $ 15,500 to get the normalized revenue and operating income, I used a normal distribution with a mean of $ 15,500 and a $7776 (50% of the mean) standard deviation. This reflects the price distribution in the past 2 years.
In the base case scenario above, I used a 35% CAGR. In the simulation, I’m assuming the future growth rate will be normally distributed around a mean of 35% and a standard deviation of 5%.
The results is a normal distribution with a $ 187.30 mean and $ 106.8 standard deviation.
Conclusion
I believe Coinbase is a company with the potential of becoming a leading crypto exchange with a possible regulatory moat around its business. However, even after a 50% drop, it’s still overvalued by around 20%.
Considering the several risks ahead, including Bitcoin’s price variance, growth uncertainty and regulatory framework, a safe entry point would be around $ 113. According to the Monte Carlo simulation, if Coinbase will reach this point, it will have a 75% probability of being below the actual fair value, giving a good margin of safety.