How To Back A DeFi Project That’ll Go The Distance

Jonathan Hobbs

3 months ago4:52 mins

How To Back A DeFi Project That’ll Go The Distance

The prices of DeFi investments have turned a corner recently, with FTX’s DeFi Perpetual Futures Index (DEFIPERP) up around 60% since last month’s low. And while none of this guarantees that the sector is out of the woods yet, it’s an encouraging sign that the DeFi tide might be rolling back in. So if you’re looking to ride that wave, I have a simple way to find the projects that stand to perform the best.

Why is DeFi on the up and up?

As the chart below shows, DEFIPERP closed last week rather well – by breaking above a descending trendline that’s been in play since the market top of November last year.

FTX’s DeFi Index (DEFIPERP). Chart drawn with TradingView.
FTX’s DeFi Index (DEFIPERP). Chart drawn with TradingView.

There could be a couple of reasons for that. For one thing, the overall crypto market has rallied 30% in the last two weeks, taking DeFi-specific investments with it.

For another, DeFi is arguably undervalued relative to other crypto sectors. After all, DeFi is one of crypto’s most compelling use cases: by “locking up” crypto collateral in DeFi protocols, you can lend it out to earn a crypto yield, or provide liquidity for other traders and pocket some of their trading fees. “Yield farmers” take this one step further by scouring the DeFi-verse in search of the highest crypto yields – the equivalent of flipping between bank accounts to chase higher interest rates on savings accounts.

So how do you find the best-value DeFi projects?

It would be very easy to start and end your assessment of a DeFi project by looking at its “total value locked” (TVL). That’s the value of the funds that users have deposited for things like trading liquidity or lending collateral. You can think of a project’s TVL like a financial institution’s assets under management: the higher it is, the greater its earnings potential (all else equal).

Recall that DeFi protocols are built on top of different blockchains: the chart below shows the top eight major blockchains according to the TVL in each. Clearly, Ethereum towers above the rest with over $125 billion in TVL, but that’s not exactly surprising: most of the largest DeFi protocols are built on Ethereum, after all.

Total value locked (TVL) in DeFi protocols grouped by blockchain. Source: DeFiLlama
Total value locked (TVL) in DeFi protocols grouped by blockchain. Source: DeFiLlama

Still, while TVL can give you a good indication of an ecosystem’s popularity with stakers and yield farmers, it won’t help you compare investments like for like. Terra, for example, has a TVL of about $29 billion compared to Avalanche’s $10 billion. But Terra’s market value is about 50% higher than Avalanche’s, so it’s hardly a good measure of how the two stack up against each other.

So how do you actually find the best-value DeFi projects?

The market cap to TVL ratio is basically the DeFi equivalent of a price-to-earnings ratio.

It divides a project’s market value by its TVL, putting each asset on a level playing field. All else equal, a lower ratio suggests more TVL per unit of market value.

There are two types of market caps we can use to calculate the ratio: current market cap (price x the currently available supply of coins or tokens), or fully diluted market cap (price x the supply if all the remaining supply of coins or tokens were issued today). For my money, the fully diluted version is the better supply metric to use, since it removes the impact of different supply schedules for each project.

Here are the ratios for the same eight blockchains as above, ordered from smallest to largest (best to worst) based on the fully diluted market cap to TVL ratios in orange.

Market cap to TVL ratios of DeFi blockchains. Source: DeFiLlama
Market cap to TVL ratios of DeFi blockchains. Source: DeFiLlama

Fantom, Tron, and Terra have the lowest ratios, so pound for pound, they currently offer the most TVL for their market size (though you’ll of course want to assess multiple factors when deciding which DeFi projects to back).

This technique works for the protocols themselves too. Check it out:

Market cap to TVL ratios of DeFi protocols. Source: DeFiLlama
Market cap to TVL ratios of DeFi protocols. Source: DeFiLlama

Above you’ll see 10 DeFi protocols from the best deal to the worst, according to their current fully diluted market cap to TVL ratios. And looking at the ratio, you can see that MakerDAO, Anchor, and Compound all offer good long-term value right now – just don't expect them to all go up in a straight line.

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