DeFi Investment Guide - Valuation

Framework on how to value DeFi Protocols

1. Read the whitepaper

   • Understand the use case of the protocol (Value chain within the DeFi ecosystem and does it solve a problem)

   • Advantages compared to peers

   • Has the code been reviewed? No bugs in the code - Iron Finance

2. Market Research

   • What is the Serviceable Available Market (SAM) / Target Addressable Market (TAM)

   • How centralised/decentralised is the protocol?

   • Liquidity: If there is poor liquidity it would be much easier for market manipulation

   • How does the protocol make money?

     • How are the protocol’s fees captured and are they distributed to holders?

       • SushiSwap tokens make money as fees are charged to trade cryptocurrencies on the DEX (0.05% being converted to SUSHI and distributed to users holding the SUSHI token) vs Uniswap (0.05% fee paid to the holder is currently turned off, yet it’s valued higher

   • Token Supply

     • Is the token inflationary or deflationary (tokens burned). ETH was recently changed to a deflationary model with the London EIP-1559 update. Is this reflected in the price?

     • Who owns a large percentage of the tokens? Is it community-owned or backed by large VCs?

3. Valuation Metrics

   • User Growth:

     • How many users: (100 vs 100,000 users, you would prefer the protocol with 100,000 as revenue is more diversified now)

     • Growth YoY and MoM: Indicates user adoption in the protocol which will ultimately drive revenue

   • Revenue Growth: If user growth continues then this should translate into the protocol’s earnings

   • Fully Diluted Market Value:

     • When valuing a company you will use the fully diluted share count (shares realised through options, convertible bonds, stock compensation)

     • Fully Diluted Market Value is the same thing, it uses the entire coin supply number rather than using the circulating supply

     • FDV: Market Price of coin* Total Supply (Max Supply)

   • Total Value Locked:

     • TVL: Value of assets that are currently being staked in a specific protocol

   • FDV/TVL:

     • If FDV/TVL is below one then this indicates the protocol could be undervalued and greater than 1 could indicate the protocol is over valued or that the market has priced in high growth potential

     • This metric is hard to measure due to rehypothecation (Using collateral to borrow money and then using the borrowed money again as collateral to borrow more money - Repeat Cycle )

   • Fees:

     • Network fees earned by the protocol

   • FDV/Fees (Market Value/Revenue):

     • Shows how much the market values each unit of revenue the protocol makes

     • DEX: The market is willing to pay X USD for every USD 1 in transaction fees earned;

     • Borrowing: The market is willing to pay X dollars for every dollar of interest paid by the borrower;

     • Earnings mining: The market is willing to pay X dollars for every dollar that LP generates

4. Valuation using a DCF:

   • DCFs are extensively used in traditional finance to value companies. Simply project the company’s FCF (Free Cash Flow: Earnings + Non Cash Items - Changes in Working Capital - Capex). Then discount back the FCFs using the PV formula and add the TV (Terminal Value)

   • Apply the same methods to a protocol. Project the fees earned by the protocol and discount the cash flows to present value and add the TV to work out the enterprise value (EV) of the protocol

   • EV/Token Supply = Implied Price

   • If implied price is higher than the current market price then it is likely the protocol is undervalued (assuming conservative growth projections were used)

   Now all that is left to do is compare the above metrics to other protocols (Comparables analysis) to figure out which protocols are undervalued vs overvalued in the market.