Applying Traditional P/E Ratios to DeFi Tokens: A New Perspective
The price-to-earnings ratio (P/E) has proven to be a useful way to value capital assets such as stocks, rental properties, and even, as we will now see, tokens in the DEFI space. In traditional finance, the price-to-earnings ratio (P/E) is a formula that helps us understand how investors value a company’s future growth expectations in relation to its earnings. A P/E ratio means that the market is willing to pay X dollars for every $1 generated by the company. For example, a company like Netflix has a P/E ratio of 84.2, which means the market is willing to pay $84 for every $1 earned by Netflix.
This means that investors appreciate, above the stock price, the ability of companies to generate income. They provide, in a way, cash flows on future earnings. With the emergence of DeFi in 2019, we have seen the appearance of new protocols, especially on Ethereum. Many of these protocols allow the creation of financial products capable of generating profits for both the protocol and the network where they operate. In other words, they generate cash flows by charging a small fee for their use. These cash flows can be distributed in various ways, as described in their tokenomics. For example, they can be distributed directly to participants in the protocol or used to buy and burn the native network token.
Burning native tokens (the process of sending cryptocurrencies to a wallet called a “black hole,” which no one has access to, effectively taking them out of circulation) may not seem like the most intuitive mechanism to understand how it benefits you directly. Therefore, you can think of it as an increase in your percentage of ownership in the network or protocol as tokens are burned, and consequently, an increase in your medium to long-term benefits. Since many of these protocols accumulate cash flows, the P/E valuation ratio can be a useful tool to assess how undervalued or overvalued a token may be, based on what an investor is willing to pay for its ability to generate income.
While this is not a perfect method of measuring or evaluating a DeFi token, given its technological and intangible nature, it does provide us with a macro view of the business behind the token, which is crucial and often overlooked. Startups like Uniswap Labs , MakerDAO , Balancer , dYdX , #GMX, and many others must generate revenue and profit for themselves, their investors, and users.
The formula applied to solve this equation of the price-to-earnings ratio is:
Market Cap / Annualized Earnings
Earnings per DeFi token
To properly engage in the valuation of DeFi tokens based on the earnings-per-token metric, we need to understand at least the cash flow of the protocol, platform, or network we are analyzing, and then its business model and the fees it generates. For example:
Synthetix, a protocol for issuing synthetic assets where SNX holders can stake SNX and earn fees generated through Synths exchange.
Kyber Network, where KNC tokens are used to pay token exchange fees, with a portion of KNC being burned and permanently removed from circulation, and the rest being distributed to reserve managers who stake KNC.
0x ,where fees are generated from token exchanges and distributed to liquidity providers participating in ZRX.
Nexus Mutual, where assets from expired insurance coverages are added to the main capital pool, increasing the value of the NXM token.
Aave Companies, where fees are obtained from loan interest rates, with these fees being split between lenders and the protocol. Protocol fees are used to burn AAVE tokens.
Uniswap Labs, where all transactions on Uniswap generate fees that are distributed to liquidity providers within each respective liquidity pool, with nothing going to the protocol, which self-funds with its treasury of allocated tokens.
Therefore, using the P/E ratio for DeFi tokens makes sense since many of these money protocols generate cash flows and, in turn, have properties similar to traditional capital assets. It’s important to note that DeFi tokens are unlikely to accrue monetary premiums as they primarily support the underlying protocol and are not used as a reserve asset or store of value. It seems reasonable to look at DeFi tokens through the lens of traditional assets and even start to interpret with greater accuracy when a token like SYN, UNI, BAL, or NXM is undervalued or overvalued based on the P/E ratio it provides (remember, it’s based on a relationship between its usage and market capitalization).
Regardless, looking at DeFi tokens through the P/E ratio lens can provide investors with a much clearer picture of their usage and potential future appreciation for every dollar generated. It’s also evident that the DeFi industry is still in its infancy, with very little usage activity and a low Total Value Locked (TVL). Therefore, it has a long way to go before it can compete in terms of cash flows with traditional banks or payment companies.