Why you can expect Coinbase to have a very hard time justifying its $61 billion market cap

In the days before the Coinbase direct listing, its fans and many news reports speculated that America’s largest crypto exchange would reach a market cap of $100 billion on its April 14 debut. That number was actually plausible, given its price and momentum in private markets just prior to opening day. Had Coinbase closed on the Nasdaq at over $87 billion, it would have notched the largest first-day valuation of all time for a U.S. enterprise, edging No. 1 Airbnb and second-ranking Facebook.

As it turned out, the $100 billion number was such a charismatic, aspirational symbol, and so ingrained in the new crypto mythology, that a number of news outlets last night incorrectly reported that Coinbase stood there at the close, or beat the mark during the trading day.

(Coinbase did briefly exceed $100 billion on a “fully diluted” basis near the open—meaning if you take into account every existing option, as well as all the issued shares. We’ll get to the impact of Coinbase’s big options overhang shortly.)

As it turned out, Coinbase stock finished at $328 for a valuation of $61 billion. Even at the top tick of $425 at 1:15 p.m., it was momentarily worth 20% less than the monumental number so many anticipated. Naturally, Coinbase’s starting valuation sets the bar for the future performance required to reward shareholders. At $61 billion, that bogey is a lot lower than if it was entering April 15 at $100 billion.

Nevertheless, its $61 billion cap reflects epic expectations. For its shares to climb rapidly from that summit, Coinbase needs two main things to happen. Both are essential to the gigantic jump in trading volumes required to hit the profit targets justifying a value of $60-billion-plus. First, its monthly user base has to wax to multiples of its current size, which is already five times the number at the start of last year. Second, the price of cryptocurrencies must keep rising rapidly, since the fixed fees Coinbase collects vary with those prices, especially for its best seller Bitcoin.

Coinbase will also fare far better if trading maintains its lurching, volatile pattern and doesn’t approach the stability of the bond and stock markets. Enthusiasts want Bitcoin to become mature and accepted. But the calmer it becomes, the less exchanges will reap by trading it.

Coinbase’s market share

Of course, the future of all businesses depends on what happens in their overall markets. But Coinbase can reward shareholders only if cryptocurrencies go on a moonshot so that in less than a decade, their valuation reaches something like half of U.S. GDP. Hence, CEO Brian Armstrong and his team can only partly determine how well Coinbase performs, chiefly by keeping an extremely large market share that maximizes its roster of users. The price of Bitcoin, Ether, and the other cryptos are out of its control. So is the future popularity of cryptocurrencies that will determine how much they are traded, and the degree of volatility.

Put simply, it looks like the total trading volumes in tokens overall need to be so astronomical, and Coinbase’s share of those trades so gigantic, that America’s biggest crypto exchange can’t get there. Future prices and trading volumes are mostly a guess, and Coinbase will face tough competition that will shrink its current dominance and hammer sumptuous fees that dwarf those charged for stocks and bonds.

A great Q1

In an April 6 press release announcing Q1 results, Coinbase thrilled its enthusiasts by announcing total revenue of $1.8 billion, almost 60% higher than for all of 2020. It estimated net income of $730 million to $800 million—even the low range would be around double last year’s figure. Accounting for those extraordinary gains was an explosion in the trading that generated almost 90% of revenues to $355 billion.

Looking at those results, you can see why investors bestowed a $61 billion valuation. If you extrapolate $750 million in profits over four quarters, Coinbase would earn $3 billion this year, resulting in a relatively modest price/earnings ratio of 30 (including options in the wings). By those metrics, it’s not a high-flier at all. When you think about its advertised growth prospects, you might argue that its shares are a great deal.

An uphill climb

Now, let’s examine the kind of returns investors will demand of this ultra-risky stock and its chances of maintaining anything remotely like the amazing numbers posted in Q1. Coinbase is partly a proxy for the future of cryptocurrencies. As it acknowledges, future results will be extremely volatile, mirroring the careening fortunes of Bitcoin and the other cryptos. To compensate for the rough ride, shareholders will want outsize gains.

Let’s posit that Coinbase needs to deliver returns of 10% a year. In that scenario, its price would nearly double from $328 on April 14, to $640 by the spring of 2028. But its market cap, as officially measured, would far more than double. That’s because it has around 76 million shares-in-waiting based on options, restricted stock units, stock granted for acquisitions, and awards reserved for the future that aren’t yet counted in its 186 million total, but will eventually swell the float. Adjusting the eventual share total to 262 million, Coinbase’s valuation in 2028 would be $160 billion.

Even at a big P/E of 30—suggesting years of rapid growth ahead—it would need to earn around $6 billion annually in seven years. Once again, that doesn’t seem such a stretch, since it made some $750 million just in Q1 of this year. At something close to that pace, it would only have to double profits by 2028, notching 10% annual increases. Sounds eminently doable.

The revenue equation

By my analysis, Coinbase would need around $15 billion in revenues by 2028 to deliver that 10% return. Let’s project that it diversifies into providing market data and other businesses, so that the portion of sales from trading falls from almost 90% to 75% in eight years. In that event, around $11.25 billion in 2028 would flow from trading.

Where would total trading volumes of cryptos stand to provide over $11 billion in revenues? The most dazzling of the sundry stunners from Q1 was that Bitcoin’s fees are averaging 0.46% on every dollar in Bitcoin, Ether, and other tokens that it buys and sells. That’s 46 times the 0.01% that Intercontinental Exchange, owner of the NYSE, and Nasdaq Inc. generate from their trades. Coinbase’s huge profits are catnip for rivals that will hammer those fees, a trend that Armstrong acknowledges as inevitable.

We’ll make the generous forecast that in seven years, those 0.46% charges fall to an average of 0.10%, still 10 times the figure for the big equities exchanges. In that case, Coinbase could reach $15 billion in revenues by achieving $15 trillion in trading volumes.

Keep in mind that on an annualized basis, Coinbase generated $1.4 trillion in trades in its extraordinary Q1. It would need a dollar number that’s 10 times higher by 2028. Where would those extra dollars come from? The two sources: a big rise in the number of monthly users, and a continuation of the raging trajectory in the prices of Bitcoin and other cryptos, a climb punctuated of course by deep valleys along the way.

Why getting there is borderline impossible

We don’t know how much each factor could contribute, just the total of what they must do together. Let’s posit that each accounts for half the $10 trillion increase in trading volumes that are needed. Once again, Coinbase needs at least a 10-fold increase from a possible $1.4 billion this year to $15 billion. Hence, Coinbase could get there through a combination of multiplying its monthly users by between three and four, a leap from 6.1 million to over 20 million, and benefiting from an equal, three-plus fold jump in the price of cryptocurrencies. A bit over three times more users and three times and a fraction higher prices, multiplied together, gets us to trading volumes that are 10 times higher.

What are the chances both will happen? The overriding requirement of getting to $15 trillion in trades may in and of itself present an insurmountable barrier. Last year, all global crypto transactions came to $4.5 trillion. So Coinbase alone would need to control the equivalent of today’s entire trading volume in seven years. Can the overall market get big enough to make that possible?

On to customers and prices. The number of Coinbase’s monthly users has already quintupled since Q1 of 2020. Reaching 20 million, given the certainty that competitors will crowd its space, looks like a fantasy. In its Q1 press release, Coinbase spelled out three possible forecasts for 2021. The “high” estimate predicts 7 million average users, but the “mid” outlook has the number falling to 5.5 million, and the number for “low” is 4 million. The subtext: Coinbase has little or no idea where its user base is headed. A march to 20 million seems a long shot.

How about the requirement that crypto prices explode? The tokens move closely together, and Bitcoin, which accounts for the lion’s share of Coinbase’s trading, sets the pace. To provide the other half of the 10-fold rise in dollar trading volumes, it makes sense to predict that Bitcoin would lead the way, going from $60,000 to $200,000. Of course, the signature token has already risen fivefold since September. Getting to $200,000 looks like a cinch for Cathie Wood of ARK Invest, who’s calling for a rocket ship to $500,000.

Buying Coinbase at $61 billion is all about believing—believing that users will go to the hundreds of millions, that Coinbase will keep a huge share of them, that Bitcoin’s price will hop from peak to peak for years to come, and that crypto trading margins will remain the highest of any popular asset on earth. That’s just too much to believe.

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