Decentralised Finance (DeFi) is constantly evolving and new protocols are emerging constantly. It could be difficult to keep a track of every DeFi project and to determine whether a project is undervalued or overvalued. The fundamental analysis could help determine whether a particular project is the right investment choice or not and some indications could help investors and traders make better investment decisions.
Total value locked or TVL refers to the number of tokens that are locked in a DeFi protocol. It could simply refer to the amount of liquidity within the liquidity pools of a marketplace. TVL is an important indicator to determine the interest of the users and the staked tokens in the project. It is also a useful comparison tool to compare different protocols.
TVL could be measured in different denominations, for example, TVL staked in Ethereum projects could be measured in USD or ETH.
The Price-to-Sales Ratio (P/S Ratio) is traditionally used to compare the price of the company’s stock to its revenues. This ratio determines whether the stock is undervalued or overvalued. A similar ratio is also very useful in analysing DeFi protocols as these protocols already generate revenue.
The revenue in the case of DeFi is earned from the transaction fees that include fees earned by the liquidity pool providers and the token holders as well as the fees retained by the protocol. It can be used in DeFi by dividing the market cap of a protocol by its revenue. The higher the ratio, the more overvalued the protocol is, and vice versa.
Tracking the supply of tokens on crypto exchanges is another indicator used to evaluate a project. Investors usually go on to centralised crypto exchanges (CEXs) to sell their tokens. But, there are other emerging options too for users such as decentralised exchanges (DEXs) that do not require any intermediary. However, CEXs tend to provide much larger liquidity, and hence, it is important to gauge the token supply on CEXs.
Usually, larger volumes of tokens observed on an exchange are associated with sell pressure as big investors tend to hold their funds in offline wallets and if they bring them on an exchange, it indicates that they are looking to sell them.
However, this is not so straightforward as traders could be holding their positions as collateral to trade on futures and margins. Thus, a large exchange balance may not necessarily indicate a sell-off always but it is an indicator that is still useful in providing an overall valuation of DeFi protocols.
As we observed, keeping a track of the token supply on an exchange is useful but it is not adequate to just look at the balances. Observing the recent changes to those balances is an important indicator as large changes to the token balances can indicate increased volatility.
For example, consider a scenario where investors are withdrawing large funds from the exchanges, signalling increased accumulation of the token. If investors were interested in selling the tokens, they wouldn’t seek to withdraw funds to their wallets. This is how buy and sell signals can be observed by monitoring the token movements.
The unique address count of the tokens is a useful indicator as the growth in the count indicates the rising popularity of the project.
Although a useful indicator, it is also subject to manipulation as a small group of people may create multiple addresses within a short period to indicate rising popularity. Hence, this indicator should be used along with other indicators to evaluate a DeFi project.
TVL when used by itself could be a good indicator to analyse a DeFi project. But sometimes, one may miss out on smaller budding projects by simply relying on the TVL alone. In such a case, the TVL ratio is a good measure that is derived by dividing the token’s market cap to its TVL.
The TVL ratio helps identify smaller promising DeFi projects and a smaller TVL ratio indicates an undervalued project with further growth potential.
DeFi protocols differ vastly by the yield they provide and liquidity pool staking is a lucrative way to earn investment income on DeFi platforms. Thus, observing the yield earned from LP staking could be a useful indicator to track.
However, as the DeFi protocols are volatile, it is ideal to look at the annual yields rather than the shorter-term yields. As the project becomes more popular, yields are likely to decrease. Hence, annual yields could be a good metric to identify promising DeFi projects with further growth potential.