A Simple Ratio to Find Undervalued DeFi Investments?
With bitcoin in a downtrend, an important question comes to mind. Is now the time to look for undervalued DeFi investments?
While most crypto assets could easily dip further from here, finding value in the DeFi market is easier today than it was two months ago. In this article, we will examine a simple ratio to help us do just that.
What is DeFi?
DeFi stands for “decentralized finance”. This is a movement that aims to cut out centralized middlemen (such as banks, exchanges, and lending and borrowing platforms) from complex financial transactions.
Here, all transactions take place through automated smart contracts, such as those programmed on the Ethereum blockchain. Through various DeFi protocols, we can easily lend, borrow, and trade digital assets.
None of these funds are held by a central party at any time. Instead, they are “locked” inside a protocol and used as lending/borrowing collateral or trading liquidity.
In the world of DeFi, the laws of finance are written in the code.
How much value is locked in DeFi right now?
The below chart from defipulse.com shows the total US dollar value currently locked in DeFi protocols. This metric is abbreviated as ‘TVL’. We can see from the chart that the TVL in the DeFi market risen steadily over the last year.
Of course, this has a strong relationship with the surge (and subsequent drop) in the overall crypto market. This is because the dollar value of the digital assets locked inside these protocols has also fluctuated with the market.
There are many different DeFi protocols, each with varying degrees of success. If we go by the current TVL on Defipulse, the top 10 are listed below:
Top 10 DeFi protocols by Total Value Locked (TVL). Source: Defipulse.com. Note: this is mostly on Ethereum and does not include Binance Smart Chain projects such as Pancakeswap.
The above data gives us a good indication of which protocols are used the most. But it does not tell us anything about the relative value of each investment. Aave might have the highest TVL, but is the AAVE token trading at a good price compared to the Uniswap token, for example?
The ‘market cap to total value locked’ ratio:
The market capitalisation of a digital asset is equal to its current supply multiplied by its current price. This is a much better way to compare the relative value of different crypto investments because it puts each asset on a level playing field.
AAVE, for example, has a market cap of around $4 billion and is ranked 28th on Coinmarketcap.com. Uniswap has a market cap of around $13 billion and is ranked 10th place by market size.
And yet, Aave has over twice the TVL of Uniswap. While these two protocols are used for completely different purposes (Aave is for lending/borrowing and Uniswap is a decentralised exchange), one would expect that protocols with higher TVL would be valued higher by the market.
In other words, DeFi protocols with higher TVL values should (other things being equal) have higher market caps.
To standardise the above, we can use a simple ratio:
Market Cap to Total value Locked = Market cap ÷ Total Value Locked
Using market cap data from Coinmarketcap.com and TVL data from DeFi pulse, we can calculate the ratios of each of the top 5 DeFi protocols by TVL:
The above numbers suggest that Curve’s CRV token offers the best value out of the group. This is because it has the lowest market cap to TVL ratio.
If we compare Curve to Compound, for example, we can see that they each have a TVL of about $7.3 billion. However, the CRV token has a considerably lower market cap than the COMP token.
Uniswap is the most expensive based on the market cap to TVL ratio.
Conclusion
The market cap to TVL ratio seems a simple and sensible way to compare the relative values of DeFi protocols. If value investing is your thing, then this ratio could be a valuable addition to your analysis.
The rationale here is straightforward. Undervalued protocols should, over time, converge to their true market values. The more undervalued they are, the bigger the discount.
With that said, there are many other factors that influence the value of DeFi protocols. Just as the price to earnings ratio doesn’t always work with stocks, neither will this.
It would be unwise to use it blindly.
