Master it Monday: A Framework for Valuing DeFi Protocols
An analysis of DeFi applications using traditional and specific metrics to unpack how blue chips accrue value and route it to their community
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Valuing DeFi protocols has become somewhat of a debated topic because of their limited track record and uncertain future, but here we will take a look at what fundamentals we can look at to at least begin comparing the value of DeFi projects with one another.
For the purpose of giving an example valuation that remains constant, we will mainly be taking a look at Uniswap and Sushiswap, with outlier examples inserted where relevant.
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A good place to start when trying to value a DeFi protocol is to try and look at it like you would any other kind of equity. To understand the absolute fundamentals of it’s quantitative aspects compared to comparable assets. For DeFi a simple pair to look at is market cap / total value locked. MC/TVL gives you an initial sense of how much of the value that a protocol is generating is being captured by the token. However, ratios that utilize TVL are best for comparing protocols that are in the same niche. So it is somewhat effective to compare two DEX’s with TVL, but comparing a DEX and a yield aggregator, not so much, because the reasons why people are locking up capital are totally different.
A better reference when initially comparing DeFi protocols of any niche is market cap / fully-diluted value. Fully-Diluted Value refers to the market cap once all outstanding tokens are issued. So for example Uniswap has an outstanding issuance of almost 500 Million of their 1 Billion total tokens. Sushiswap on the other hand has already issued about 190 Million of their 250 Million total. This gives UNI a MC/FDV of 51.9% while SUSHI has a MC/FDV of 75.6%. What this means is that UNI will need more demand than SUSHI for the price to go up in light of the increase in supply. To give a sense of how extreme things can get, YFI has a MC/FDV of 100% while CRV has a MC/FDV of 10%. Subtleties like this can make a huge difference in long term price movements, and are often overlooked by inexperienced investors.
As a valuation metric straight from traditional finance, one that translates well is a protocol's Price / Sales ratio. P/S simply represents the market cap divided by total sales (revenue). For example If you extrapolate Sushiswap’s revenue for the last month of $59.9M USD and multiply that by 12 for every month of the year, you get $718.8M. Now if you take the fully-diluted market cap of $1.75B and divide that by the $718.8M you get a P/S of 2.48 which is incredibly good. In comparison if you run this same calculation on Uniswap you get a P/S of 9.86. When given these numbers it would indicate that you might wanna take a closer look at SUSHI.
Some of the premier DeFi projects ranked by P/S (Via Token Terminal)
While TVL can be used to compare DeFi assets in the same markets, there are some more specific metrics that can be used to compare assets that tell you a lot more about the protocol in question; They can be sorted into DEXs, lending, yield aggregators and derivatives protocols.
For DEX protocols a key metric to track is volume. This is pretty straight forward. Above all else, what measures the health of a decentralized exchange is how much people are using it to transact. Volume trumps total users because a platform like Uniswap might get more of the people that are new to the space because of positioning, but if proportionately more experienced users who have larger pools are capital are preferring to use Sushiswap, that says something positive about Sushiswap that wouldn’t be picked up by just looking at the number of users.
Weekly volume by DEX (Via Dune Analytics)
Similarly, for lending protocols like Aave, Compound and Maker, the fundamental metric to look at would be the total amount being borrowed. If the amount of funds being borrowed from a protocol is consistently growing, that is likely a sign of a healthy protocol worth keeping an eye on.
For derivatives protocols, it would be best to look at total outstanding debt.
For yield aggregators, it would be best to look at deposit and withdrawal amounts
As you may notice, what these metrics all have in common is that they measure both usage and profits for the protocol, as all of these metrics are what the protocol collects fees from. Since these metrics measure the sources of which protocols accumulate fees, if the token of said protocol distributes fees now or in the future, it is that number which will determine how much is being paid out, which obviously determines a lot in the valuation of the asset.
Potential Market Size
For potential market size, it is important to look at the current size of the market the protocol is in, it’s potential future size, the protocols possible expansion to new markets, and the protocols potential to acquire a sizable share of said markets.
To stick with the Uniswap / Sushiswap example, the current size of the DEX market is around $20 Billion USD. Uniswap takes up about half of that, however the total market for crypto currency exchanges is roughly a couple hundred billion when you include companies like Coinbase and Binance (many private valuations so can’t be totally sure on numbers), which could still multiply by a factor of five over the coming decade. Combine that with the potential for a huge amount of traditional financial assets like stocks coming on chain, the potential goes up by another large multiple in the long term.
Projections of total users of cryptocurrency over the coming decade (via GMI)
As for expansion to new markets, it has been discussed that UNI could become an oracle token, a potentially huge future market and one where chainlink already has a current market cap of almost $10B.
Sushiswap on the other hand is rapidly transforming into a one stop shop for all things DeFi, with more products coming out almost monthly. This is a potentially huge play that also has limited downside.
Variables like these must be factored in to give a true representation of potential future price.
Tokenomics / Value Accrual
As we started to indicate earlier by comparing market cap with total value locked, it is important to inspect how much of the value a protocol is generating is accruing to a token. A protocol can be doing well by every standard, but if it is not driving value to the token that can’t be looked over. This is why it is especially important to look at the metrics that drive fees and ultimately profits for a protocol as we have also pointed out.
What is also important to look at here is whether the “fee-switch” has been turned on for a given protocol. The fee-switch simply indicates whether a portion of the fees that the protocol generates are distributed to token holders. The fee-switch decision is made by token holders as part of the governance process. It stands to reason that most assets will eventually make the transition (If people can vote to make the assets they own more valuable, they likely will), however it is important to note whether that transition has been made *now*, as for many protocols it could still be years away.
Holders of SUSHI can stake their SUSHI for xSUSHI to accumulate dividends from the protocol
While some of these can be unclear given how relatively early we are in the development ecosystem (what seems like a huge advantage can actually be evaporated rather quickly) a protocol having a separating factor that acts as a “moat” can go along ways in preventing competition from arising in an industry where existing projects can be carbon-copied rather quickly. For example, in the yield aggregator space Convex is finding out that it is hard to go up against a first moving incumbent like Yearn.
Something else that is incredibly important to look at is how devoted the community is. A strong community can act as the world's greatest marketing department in some cases. Crypto as a whole is a great example of this! For a more tangible example look at LINK and link marines. The best way to gauge a community is by checking out the discord (or telegram). In the discord if you’re really curious you can request the engagement stats from an admin. What you’re really looking to see is whether the project has an army going around spreading its gospel. And if it does, that is incredibly valuable.
Team / Development
When assessing a team, it is important to attain an understanding of both their competence and character. Competence for obvious reasons, but character is also integral in DeFi where a malicious move by the team can come at the cost of millions from users.
A good team is one that has a track record of innovating in the space, and has shown a propensity to make long term oriented decisions.
Anonymous or not, it is important that a team has a good track record in the DeFi space.
The wildcard here is anonymous founders. There’s no way around it that with anonymous comes increased risk, as their friction to run an exit scam is much lower. However that is not to say an anonymous team can’t be a great team. The point is to say that it requires much more of an intangible inspection into what their intentions are. Try and find as much content as you can where it’s either them speaking or have written something and listen to your gut.
On the flipside, the benefit of having an anonymous team is that the project is inherently more decentralized, and if a legal crackdown on DeFi and crypto occurs, that is a major asset.
The biggest risks in DeFi result from errors in code and malicious developers. One should be cautious of valuing too highly a project that doesn’t have a long track record of keeping funds safe.
If investing in early stage projects, an audit done by a reputable firm is essential.
As an asset class, it is true that it can be difficult to put an accurate valuation on DeFi projects. That said, it is also true that it’s not quite as hard as some people make it out to be. Hopefully this guide has given you a better approach to viewing potential DeFi investments. The game at this point is all about finding projects that have great underlying fundamentals, whether that be quantitative metrics, a great community or a great team that other people have not fully picked up on yet. You can never be truly confident in the investments you're making if you just rely on the word of someone else. It’s up to you to go in the trenches and really learn the ins and outs of the project to see if they're really on to something and then make an informed decision from there.
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⚠️ DISCLAIMER: Investing into cryptocurrency and DeFi platforms comes with inherent risk including technical risk, human error, platform failure and more. At certain points throughout this post, we might get commission for promoting certain projects, if this is the case we will always make sure it is clear. We are strictly an educational content platform, nothing we offer is financial advice. We are not professionals or licensed advisors.
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