SUMMARY
Thanks to Ethereum and other smart contract platforms, a new generation of decentralised applications is being created. The main use that is being given for now is in the finance industry.
As in any new industry, particularities arise and the KPIs (key performance indicators) change based on these peculiarities, in this article we highlight some of the most important ones so that the new crypto investor knows how to value and understand DeFi protocols.
Please keep in mind that as usual in the blockchain world, most of these metrics can be found online for free (for example, at DeFi Pulse).
TOTAL VALUE LOCKED (TVL) vs MARKET CAP
Total Locked Value (TVL) represents the number of tokens multiplied by their value in $USD that are included in a DeFi smart contract. In a simplified way, it would be the sum of all the liquidity provided within the liquidity pools (LP) of the protocol.
The market cap is simply the value of the total tokens multiplied by the price in $USD. It should be noted that the number of tokens in circulation may not be the total number of tokens that will be in circulation in the future. If you want to take into account the maximum total tokens in the future, you should check it out, for example, in the case of BTC there are a max of ~21M tokens when at the moment there are ~18.6M in circulation.
Market Cap / TVL as a metric has been adopted as one of the main ones to take into account in DeFi, as DeFi products are being adopted it is interesting to compare this metric between different tokens to see if one or the other is undervalued in a relative way (the lower it is, the more undervalued the token is in theory), keep in mind that it will not be the only indicator to take into account to determine this but it is a start.
TVL can also be used separately to see the share that a project represents of the total DeFi universe.
PRICE vs SALES RATIO (P/S)
The traditional stock market has these types of ratios, most notably the P/E ratio (price vs. earnings) which are used to determine if a stock is overvalued or not, it is mainly used to compare the price of the stock against sales and it’s useful to check if other competitors have a similar one.
DeFi products also generate profits (for example, Uniswap does it in the form of fees when exchanging tokens), therefore we can determine the price vs sales ratio. As with Market Cap/TVL, the lower this ratio, the more undervalued a certain token could be compared to others within the industry.
Check on this website P/S ratios for some of the most relevant tokens.
USER GROWTH RATE
Although it is difficult to determine how fast a decentralised product grows in number of users, a rough growth rate can be determined by looking at how the number of wallets with tokens increases, however a user could create a large number of wallets and it would seem that there are more users than the real amount that actually use the product.
Logically, the more portfolios you have created, the more theoretical users are adopting the product.
DETERMINISTIC vs SPECULATIVE VALUE
To explain what the deterministic value is, we are going to use the example of Thorchain (token $ RUNE). In this protocol, the value of $RUNE must by design always be three times the value of the rest of the tokens provided in its protocol (LPs), so if the value of the liquidity pools grows, so will the value of $RUNE. We will do another post explaining the reason for this design and how it works.
As in the Thorchain example, it is essential to understand what value the token brings to a protocol and what functionalities it has. Easier said than done, and it's probably more art than math, but if we succeed we will understand what minimum value a token should have and we could determine which protocols are less speculative and therefore more sustainable as a value investment.
RISK METRICS TO KEEP ON YOUR RADAR
INFLATION RATE
You should take into account the amount of tokens that are created daily and if the creation rate will decrease or grow in the future (for example, Bitcoin will have 21M tokens and as more tokens are created, the more difficult it is to create new ones).
An example of this risk is in Bao Finance, it has very good Market Cap/TVL ratio, however there is only a small part in circulation of the total tokens compared to the amount there will be in the future. This is not necessarily bad, since Bao Finance is constantly burning tokens, so you really have to understand the true rate of inflation and the reasons behind it.
SHARE OF TOKENS AT EXCHANGES vs PRIVATE WALLETS
If the percentage of tokens that are in exchanges (Binance, Coinbase, etc...) is high, sales can occur more suddenly than if the user has it in their private wallets. The flow of these tokens must also be understood, if there have been large changes in the number of tokens that are in these token exchange markets, that could mean a shift in sentiment towards the project.
However, this metric is the one that least convinces me personally, since a large part of the token exchange volume happens in decentralised markets such as Uniswap and Sushiswap where the user does not have the tokens stored. In addition, these decentralised markets have an increasing market share, especially in DeFi.
PROTOCOL SECURITY
Numerous hacks happen in this industry annually, so despite all the economic metrics that we can obtain, if the protocol has not had security audits from third parties, the risk profile will grow and the investment to contribute could decrease by inverter function (a security audit does not mean a protocol can’t be hacked or exploited but it is definitely better than doing nothing).
Other than the code being secure, we must also take into account the influence of the founding team, if they are reliable and what possibilities they have of suddenly leaving with the funds (rug pull), lowering the price of the token drastically and with a lack of liquidity that would prevent us from selling.
BUSINESS (& TVL) DEFENSIBILITY
Similar to checking a protocol security, you should try to evaluate why a product is not only good now but will also be good in the future. In other words, it prevents other products from 'stealing' the market share of your investment. Especially when the code can be easily copied, the most notorious case was that of Sushiswap, which did what is called a vampire attack on Uniswap, gaining a large market share as a consequence (read this post for more info).
For this matter there is no exact science, but we can focus on understanding the features that are not easily copied of a DeFi protocol, some of them are: partnerships with other businesses, a strongly engaged community, a token issuance calendar attractive that makes the investor want to keep their funds at the project...
FINAL THOUGHTS
There are a wide variety of metrics that can help us determine whether or not a DeFi protocol is undervalued. What we try to do is implement metrics from existing industries and adapt them to the blockchain world, however, they will have to be further understood and evolved and to understand the fundamentals of DeFi other metrics need to be created as with any new industry.
This is not an advice to invest, everyone is responsible for using these metrics freely and in the way they think appropriate. Always do your own research.
