Coinbase Global Inc. (COIN, Financial) is the largest crypto-specific exchange in the United States of America. It has over 68 million verified users, which trade approximately $462 billion in crypto volume. According to data from Statista , this makes the company the 13th most popular exchange in the world, with Binance at number one, although it isn’t public yet.
However, Coinbase was a crypto exchange pioneer. Founded in 2012, it was one of the first easy-to-use and trustworthy cryptocurrency exchanges. Binance launched five years later in 2017.
How Coinbase makes money
The company allows investors to trade in over 140 various crypto assets, which include Bitcoin, Ethereum, Cardano and even dogecoin. Coinbase makes the majority of it revenue from order flow and the buy-sell spread from retail and institutional investor trading. The company charges a spread of approximately 0.5% for all transactions, in addition to fees of 99 cents. There is also a crypto wallet that allows customers to store cryptocurrencies, with no fees.
The most exciting thing about Coinbase is it has a vision to build the “crypto economy.” This is set to be a fair, efficient and transparent financial system enabled by cryptocurrencies.
The company is investing heavily into research and development; around 10% of capital, according to the CEO, with 70% going to improve the core business and 20% into strategic investments.
Among Coinbase's other services is Bitcoin Borrow, which allows users to borrow money using bitcoin as collateral. It offers the Coinbase Card from Visa (V, Financial), allowing users to spend their cryptocurrency on everyday purchases. It also has a cloud-based API and blockchain infrastructure product, aptly named Coinbase Cloud, which allows decentralized applications to be built on top, offering a similar vision to a mini Amazon Web Services.
In a gold rush, sell shovels
If you are looking for a method to invest in crypto indirectly without picking up the latest coin, then this could be a great investment. I liken this to the old adage, “when there is a gold rush, sell shovels." This refers to the majority of people wo made money in the California Gold Rush were those selling shovels, pickaxes and even Levi’s Jeans, rather than trying to mine the gold. This is the same strategy as investing into a crypto exchange.
Founder and CEO has skin in the game
Coinbase was founded by Brian Armstrong, who as the CEO has many exceptional founder traits, which I have picked up on from interviews. These include a long-term vision, deep knowledge of the industry and a strong work ethic.
Apart from these traits, Armstrong is putting his money where his mouth is. He owns approximately 17% of the company, which means he has skin in the game. Investing with great founders who have skin in the game is a strategy I and many successful hedge fund managers use. These include Nick Sleep, whose Nomad Investment partners averaged 20.8% returns for 12 years by investing the majority of the fund in Amazon.com Inc. (AMZN, Financial), and Jeff Bezos.
Coinbase is also backed by leading venture capitalists, which include Andreessen Horowitz (6%) and LinkedIn co-founder Reid Hoffman's Greylock (0.29%).
Investing risks
There are some risks associated with investing in the company as well.
1. Volatility of crypto trading
As Coinbase makes the majority of its revenue from trading volume, this means a bet on the stock is a bet on the popularity of cryptocurrency trading, which is notoriously volatile.
If crypto crashes and people stop trading as much, as happened previously in 2017 and even in the third quarter of 2021, then the company's revenue plummets.
As you can see from the table below, the number of monthly transacting users was down from 8.8 million in the second quarter of 2021 to 7.4 million in the third quarter. This directly impacted the trading volume and net revenue, which was down a whopping 39%. This was an even greater decrease than the 29% decline in trading volume.
From the table below, you can see the majority of trading volume, between 40% and 50%, is from the two most popular crypto assets (Bitcoin and Ethereum). Thus, expect the price of Coinbase's stock to be tied heavily to the success or failure of these two assets.
2. Commodity exchange
Cryptocurrency can be traded on many different exchanges and from many different brokers, from Binance to stock trading apps such as Robinhood (HOOD, Financial) and even fintech apps such like Block's (SQ, Financial) Square.
Thus, the offering by Coinbase is not unique. Now this could change in the future if the investments it is making pay off. However, at the moment, the company is selling a commodity or, in economic terms, a good with “perfectly elastic demand.” As such, people will trade at the broker with the lowest fees, which causes a race to the bottom.
3. Insider selling
Coinbase insiders are selling plenty of shares and the venture capitalists are cashing out. Horowitz was selling at $230 and Armstrong sold at $410. Although I don’t blame the CEO for selling at $410 per share (stock is now trading at $210), I would like to see some buying by insiders at these low levels.
Is the stock undervalued?
To value Coinbase, I have plugged the latest financial details into my advanced valuation model. This uses the discounted cash flow method of valuation. However, I also take into account option expenses and other extra considerations.
Being conservative, I have estimated revenue growth for next year of just 5% (given the massive 39% decline in revenue for the third quarter of 2021). I also expect revenue to increase 20% on an annual basis for the next two to five years.
(Valuation Models Source: Motivation2 Invest)
The company has a fantastic 40% operating margin, which I expect to remain steady, and over $6 billion in cash. Given these figures, I get a fair value of $231 per share. Since the stock is currently trading at around $208 per share, it is undervalued by 11%.
Final thoughts
Coinbase is a fantastic crypto exchange. The company is making many investments to build the “crypto economy,” which offers an extra “optionality” value to the stock. The company is founded by a tech visionary and offers vast potential for the future.
However, as the company's revenue is tied heavily to the popularity and volatility of cryptocurrency trading, it can be seen as a major risk. Some people may also view the stock as an opportunity akin to investing in a crypto exchange-traded fund. The stock is undervalued right now and, therefore, could be a sensible addition to a diversified portfolio in place of crypto assets directly.
