Analyzing Token Economics
Hey DEFI TIMES community,
In DeFi, we are replicating the traditional financial system. The times when tokens had no utility are long gone.
Today, coins/tokens are commodities, capital assets, debt, cash-flow-producing, NFTs, and much more. Today, we want to focus on cash-flow-producing tokens, aka capital assets, which means tokens bring investors monetary value.
There are two ways of using cash-flow to benefit the community: Protocols either use the cash-flow to burn tokens or emit it to the token holder.
Maker (MKR) is a great example of a token burn mechanism. The Maker Protocol generates revenue, using it to buy back and burn the MKR token, ultimately reducing the token supply - similar to stock buybacks.
Kyber (KNC) is an example of a token emitting revenue to token holders. The Kyber Protocol generates revenue through fees. KNC holders can claim part of the cash-flow.
Today, we want to focus on how to value those tokens. The good thing is that we already have traditional methods of valuing stocks. Those methods can be applied to the decentralized version of companies: protocols.
Let’s see what the most important token metrics are!
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Protocols produce cash flow, mainly by charging fees from their users. Uniswap, for example, charges a small fee every time a users makes a token swap. The fees are then paid out to liquidity providers.
Therefore, the total amount of protocol revenue equals the amount of money paid to the Uniswap liquidity providers. In the case of money markets like Aave, the protocol revenue equals the amount of money paid by the borrowers.
Revenue is a crucial metric because it shows the value users are willing to pay for the services. The higher the value, the more people provide liquidity to the protocol - the more liquidity, the lower the slippage.
Liquidity begets liquidity - and it ultimately comes down to how much revenue a protocol generates.
We have to distinguish between protocol revenue and protocol earnings - it’s the exact difference between company revenue and earnings.
While the revenue is the money users are willing to pay to the protocol, the earnings are the amount of money that token holders are eligible to receive; however, not every token actually emits those earnings to its holders. There are multiple ways they can benefit.
1. The protocol could use the earnings to buy back and burn the token to reduce the supply (For example, Maker)
2. The protocol could emit the payments to the token holders (For example, Kyber or Sushi)
Market Capitalization (MC) vs. Fully Diluted Market Capitalization (FDMC)
When you take long-term positions in any kind of token, it is essential to look at the fully diluted valuation. Often there’s a huge gap between the market cap and the fully diluted one.
You calculate the fully diluted valuation by determining the total amount of tokens that will ever be in existence.
If the discrepancy between MC and FDMC is significant, you can expect that many new tokens will enter the market at some point. You should expect a lot of selling pressure in the future - either because tokens are minted out of thin air, or team members/investors hold a significant portion of the tokens.
I prefer tokens that have little to no difference between MC and FDMC - at least in the long run.
Especially new protocols tend to have issues with FDMC. So, keep an eye on this metric!
The price to sales ratio is a metric mainly used in traditional finance to analyze companies. It compares a protocol’s market cap to its revenue.
P/S ratio = market capitalization / revenue
The higher the P/S ratio, the higher the relative valuation - meaning that investors expect future protocol growth.
The P/S ratio says that the market is willing to pay $X for every $1 generated in revenue. Companies in growth industries (tech, …) tend to have a higher P/S ratio than companies in stagnant or established industries (automobile, …).
In the case of Uniswap, the P/S ratio translates to this: The market is willing to pay $X for every $1 generated in trading fees.
In the case of Aave, the P/S ratio translates to this: The market is willing to pay $X for every $1 generated in interest paid to lenders.
Total Value Locked (TVL)
The total value locked is a key metric to look at when you decide whether any token’s valuation is appropriate. The TVL equals the amount of capital locked inside a protocol. The more capital inside a protocol, the better - and the healthier.
It’s a metric indicating how much trust users put into a protocol. Smart contracts are risky, and hacks are everywhere in the crypto space. Do you remember the Yam hack in summer 2020 - Millions of dollars were lost within seconds!
Ultimately, any protocol’s TVL comes down to two factors:
1. How much trust people have in the protocol
2. The protocol’s utility
If the protocol doesn’t give its users any value, people won’t lock their funds up. In most cases, value means a return on their assets.
People lock their funds into Aave to receive interest on loans. Uniswap liquidity providers earn yield for being market makers. Uniswap liquidity providers receive inflation rewards on the Sushi token (Liquidity Mining).
The largest DeFi protocols seem to be secure and useful. That’s why they have billions of dollars in TVL.
There are thousands of DeFi tokens on the market nowadays, and it’s hard to keep track of all of them. That’s why token metrics come in handy. We apply traditional company valuation methods to the decentralized version of companies: protocols.
P/S ratio, revenue, and earning-metrics all exist in the outside world. Some metrics are new and can only be used in the decentralized world.
There are many aspects we didn’t cover today, which are probably just as important - but not quantifiable.
The community, the narrative, the team, and problem-solving are just a few of the metrics that you have to consider but cannot represent in numbers.
However, those metrics are the foundation of every token analysis, and you have to dive deep into every one of them to take long-term positions in any token.
All information presented above is meant for informational purposes only and should not be treated as financial, legal, or tax advice. This article's content solely reflects the opinion of the writer, who is not a financial advisor.
Do your own research before you purchase cryptocurrencies. Any cryptocurrency can go down in value. Holding cryptocurrencies is risky.