DEFI Fundamentals
This post is expansion of How to make it in crypto part 3, but here I show in details how protocols are gaming metrics with token inflation (especially TVL and P/S and P/F calculations).
Valuation
The easiest way to quantify whether you are early or not is the valuation of the project. I would even specify it as a comparative valuation to a cohort of similar projects in terms of product, key metrics of adoption, level of the team etc. It’s kind of insane how little new investors are considering the valuation of the project they invest in when it literally means whether you are buying a cheap or overpriced asset. For public tokens, you should always consider valuation after you find out an interesting product.
Let’s consider an example from CoinGecko as Uniswap’s token — UNI.
Uniswap is DEX Decentralised exchange with a great product and a strong team. Look at the first line called Market cap, it is 3.828 Billion dollars, not a cheap valuation in comparison to any technology company or a defi protocol, for instance, Coinbase valuation is $16B. Also, Uniswap was founded in 2018, so you are definitely not early here. But Uni is the best defi product out here, so it’s definitely something to consider.
Now I want you to look at Fully Diluted Valuation or FDV which is 5.079 Billion dollars.
Fully diluted valuation is the total value of a project or platform, assuming all potential outstanding tokens have been issued and are in circulation, including those reserved for future issuance or allocated for team members, investors, or other stakeholders. It provides a more accurate representation of the true value of the project, taking into account potential future token dilution.
It’s actually really close to Market cap which is a good sign. Because when tokens are launched more often than not, they have a small market cap and comparatively high FDV, which literally means that protocol will print a lot of new tokens to liquidity providers who will sell these tokens in huge amounts and lower the price if there is not enough new buyers.
Unfortunately, for most of the projects, there is rarely a huge demand in 2–6 months to cover the printing of new tokens especially if FDV at launch already more than 200 million dollars. But quite often teams with good new products and high-profile VC investors launch at insane FDVs over $1 Billion and a low market cap of $10–40 million. Because of low numbers of outstanding tokens for a month price can make some gains, but over time these tokens are just going down due to high token inflation and no real demand.
A great example of an interesting product and a good team but a high FDV problem is Ribbon Finance.
The price chart is a never-ending story of liquidity providers and investors selling this token, price is 97% down, FDV is still $164 million, which isn’t that cheap btw in comparison to how little the product generating in fees. The greedy mistake was to launch a token at 5.5 Billion dollars with no real traction, investors who bought it on the day trading started never had a chance.
Interestingly, the market cap hasn’t even gone down much since the start, but a huge disparity between market cap and FDV, hence massive token inflation created this situation. Below is the market cap chart performance, where we can see that there were just enough buyers to somewhat sustain the market cap, but not the price with such massive token inflation.
Price aggregators are currently looking like a never-ending grave of such charts, RBN is not even a criminal case, just a colourful one. Ribbon has already gone through a bear market and the worst part for it is over. Not saying it’s a good buy, but just that it was incredibly stupid to buy such a token at launch, now it just doesn’t look great, yet not catastrophic.
However, there were a lot of ethereum copycats such as Solana, defi projects there went over the line, and you could easily find tokens with a 1 million market cap at launch and several billion FDV. Even after a devastating bear market, they are still overpriced. Their sole purpose of them was to enrich a small number of private investors and the infamous Sam Bankman-Fried fast, but the ecosystem as a whole now has an easily recognizable aftertaste of financial fraud.
Total Value Locked (TVL)
TVL is a metric that measures the total value of assets that are locked in a DEFI protocol or specifically in its smart contracts. The easiest example of TVL for a traditional bank would be all the deposits, for decentralized exchange all the assets they have for you to trade.
Uniswap for instance has a wooping $6.239B locked in its liquidity pools for users to trade.
TVL is tricky because it can be quite easily gamed and for different protocols it means different things. Protocols attract liquidity providers to put money into the protocol by giving them their own token (token inflation), in the case of Uniswap — UNI token. Anyone can become a liquidity provider and receive a protocol’s token.
When you hear about people earning “passive yield” in 90% of the cases it’s token inflation for liquidity provision. Protocols often use inflation to attract liquidity providers and increase their TVL. However, this can create a false impression of success as it may not reflect actual usage of the protocol.
A token can not be inflated heavily for long, because prices will collapse eventually and so liquidity providers will vanish: in the case of DEXs liquidity pools to trade will dry out and in the case of lending protocols money to borrow will shrink.
Below is an example of SushiSwap revamping its token economy to become earning-positive by reducing token incentives.
Fortunately, they were able to sustain TVL, but mainly because they diverted part of the fees from xSushi stakers to Liquidity Providers (LPs).
Price to Sales P/F and Price to Revenue P/S ratios
I should mention that they are applicable basically to every crypto asset with one exception — Bitcoin (maybe a bit Ethereum).
P/F and P/S are new metrics for crypto and people are debating how valuable they are. Though of course they were not created by crypto, they are used in a bit different forms for companies for eternity, they literally help you to understand how fast you can get enough cash flow from the company you are buying. For companies P/E, P — company valuation, E — earnings annualized (cash that business generates after all expenses), P/E = 10 means you need 10 years to get back the amount of money you spent on a company, after that you have the company and generating fresh cash.
I would honestly say that crypto is very narrative driven and metrics not always mean a lot in short term. However, if protocol can’t generate any cash flow, people are not ready to pay for service provided and protocol valuation is several billions, you would be a sucker to invest in such project. P/F and P/S are the simplest, the most basic metrics that you can’t just overlook.
Here is SushiSwap financial metrics from Token Terminal.
Let’s look at P/F and P/S numbers. P here means FDV, F means Fees traders paid (annually), S means revenue (annually) and (Calculated as Fees traders paid minus what Sushi platform pays to Liquidity Providers for their service, so S=F-(what Sushi paid to LPs from fees).
There is one caveat though regarding P/F and P/S metrics, how much money protocol is spending to attract these liquidity providers besides cut of the fees. I saw numerous people and even analysts make that mistake because they do not look deeply into protocol financial statements and actual numbers. No surprise, but most of the protocols are not making money.
Here is an example, people thought maybe GMX is “the most undervalued DEFI protocol in crypto”
Usually people don’t know that defi protocols are incentivizing liquidity providers by giving them their tokens and quite often they are net losers of money.
Interestingly GMX was a net looser of money in October, but now the protocol itself is net positive (but from even this money we should extract team’s operational expanses as their salaries, office, taxes etc to get to net income). You can see all these metrics on Token Terminal at Earnings Leaderboard.
Overall, most of the crypto protocols are early-stage companies and it’s alright for them to not turn a profit if they are trying to expand quickly and spending all their revenue on that. However, there should always be a clear path to a sustainable business model through a valuable product that makes money.
