Written by KP, Ponyo, and Do Dive
Translated by Rhea
The third topic in our Xangle Valuation Series is decentralized exchanges (DEXs).
The reason DEX was chosen as the next topic for this series, after our discussion on Bitcoin and Ethereum, is because it takes similar business models to the existing exchanges and securities firms, making it is easy to apply the traditional valuation framework, and various valuation efforts are being made based on a wide range of metrics today. In fact, most DEX projects have a clear and definite performance index in terms of their “transaction fee (i.e., revenue),” and we are able to collect data on the amount of such revenue on the blockchain. There are multitudes of services offering an easy-to-grasp view of such indices. All in all, this sector is relatively easy to understand from a valuation perspective. In this article, we will seek a brief understanding of the business model of the DEX sector, and discuss the value of representative DEX projects such as Uniswap, SushiSwap, Curve, PancakeSwap, and dYdX.
1. Decentralized Exchanges (DEXs)
1) Market Size
A decentralized exchange (DEX) is a peer-to-peer (P2P) exchange where token buying and selling, i.e., transactions, can be carried out without any mediators. Unlike centralized exchanges (CEXs) such as Binance or Coinbase, DEXs do not require any intermediaries since the transactions are executed via smart contracts on blockchains.
The DEX sector showed an explosive growth spurt in 2021 with the momentum it gained from “DeFi Summer.” Such growth gave a push for the annual transaction volume in 2021 to reach $1,800 billion, which is a 23-fold growth from 2020. The following factors are considered responsible for DEX’s growth: i) an increase in demand for high-yielding DeFi products and ii) the reflective effect against the regulations on CEXs. (For more details, please refer to "Who Won the DEX War: Uniswap or dYdX?")
An increase in transaction volume leads to an increase in the DEX protocol’s revenue. On average, DEX protocols take 0.3% of the transaction value as their fee. Such income from the commission fee allowed the DEX sector to reach a $3.5 billion revenue in the past year alone. The revenue will be utilized as a key metric for valuation in this article going forward.
Although DEXs operate on smart contracts without any intermediary trust, their business model does possess similarities to those found in the traditional financial industry – exchanges and securities firms, in particular – in that their main source of revenue is the fee they take from conducting asset exchanges. While the size of the DEX sector as of yet remains small at a mere 1% of the global stock market, which generates close to $150 trillion transactions in value per annum, given the explosive growth trend of the DeFi ecosystem, it is expected to steadily take over the traditional financial industry.
2) DEX Models - AMM and Orderbook
DEX models can be divided mainly into two methods: AMM (Automated Market Maker) and Orderbook.
Automated Market Maker (AMM) is a method of transaction that relies on mathematical algorithms to calculate the price of assets automatically. Assets are exchanged via smart contracts on the liquidity pool comprised of token pairs (e.g., USDT-ETH) without any transactions between traders or market makers. In general, over 70% of the transaction fees are paid to liquidity providers (LPs) in order to secure a sufficient volume of the liquidity pool. This would be considered equivalent to the sales cost required to make the transaction. Representative AMM models include CPMM (used by DEXs such as Uniswap, PancakeSwap, and SushiSwap) and CFMM (used by Curve).
Orderbook is a traditional method of transaction mostly used in CEXs and uses the ask and bid price methodology. In this method, the transactions are executed only when the price and amount offered by buyers and sellers match. While being able to buy and sell at the exact price of their choice means that there is no room for slippage when using the orderbook model, it also means that there is a downside that the liquidity for assets with a lower level of demand or popularity is low, making it difficult for them to reach a complete transaction. Another upside is that there is no fee given out to liquidity providers (LPs) because there is no liquidity provider in this model. dYdX is a good example of an exchange using a hybrid protocol scheme (off-chain order relay, on-chain settlement) that has incorporated the orderbook method.
2. PSR Valuation
Significance of PSR and Justification for PSR Index-based Valuations
The PSR valuation method, mentioned in the earlier article that dealt with Ethereum and Layer 1 valuation, is one of the valuation methods in which PSR (Price to Sales Ratio; Market Capitalization / Revenue) of assets within the same sector are compared to determine whether they have been relatively over- or under-valued. This index shows the market value of stocks or virtual assets against their revenue by interpreting their market cap, representing the enterprise’s value in terms of revenue multiples. Considering that it is often used to evaluate fast-growing companies that have yet to incur any or only a small sum of operating income, it is justifiable that this would be the method of choice to evaluate DEX protocols whose revenue and operating income have been around only for about 1 to 2 years.
PSR Calculation and Comparison with Peer Group
While the PSR calculations for stocks use market capitalization based on the total number of stocks issued, the PSR for virtual assets set the market cap based on supply volume as their variable since an increase in supply volume from token distribution dilutes the value of the protocol. Protocol revenue data provided by Token Terminal was referred to for the calculation in this article.
Calculation of PSRs for key DEX protocols gave us a range of PSR from a minimum of 1.81 (Balancer) to a maximum of 16.72 (Curve Finance), with a median of 3.55 (Uniswap), as shown above.
In order to determine whether an asset is under- or over-valued using PSR, the selection of peer group on which to base this judgment is a crucial part of the process. As mentioned above, DEX protocols draw on a similar business model to existing securities companies and stock exchanges in that they mediate the exchange of assets and collect fees in return. As such, we selected companies pursuing securities and virtual asset trading as their business to be included in the peer group, and their PSRs were derived as below:
When we set the fair PSR as the average of all the companies’ PSR in the peer group (7.65), Curve Finance and Bancor were found to be overvalued, and all the DEX protocols other than these two fell short of the average value of the peer group. Given that the fast-growing companies in a sector with a high growth rate generally show high PSRs, and that the DeFi ecosystem is growing at such a high speed right now, it can be determined that the DEX protocols other than Curve and Bancor are significantly undervalued.
Token Economics Must be Considered when Applying PSR
Since PSR simply reflects the protocol’s revenue only, it fails to consider any additional income that may have occurred. Let’s take Curve Finance, for example. Upon valuation using PSR, Curve Finance is shown to be relatively overvalued at a PSR that is well over twice the average PSR of 7.6.
However, Curve Finance provides CRV as a gauge reward to veCRV holders on top of their revenue. Since the adjusted PSR may be lowered when such a CRV value is considered, it is an excellent example that clearly shows that the revenue data alone is not able to adequately reflect the real value of a protocol. With protocols practically waging war to secure CRV tokens issued daily as gauge rewards other than transaction fees, the growing sentiment that the size of such bribing must be incorporated as a part of the revenue volume calculation seems to have some merit. This means that the business model of each protocol should first be identified, and the revenue variable must be set to accommodate particular characteristics of the protocols when evaluating them via PSR.
3. PER Valuation
What is PER?
The PER methodology is one of the relative valuation methods much like PSR, in which whether assets are under- or over-valued is determined using PER (Price to Earnings Ratio; Market Capitalization / Earnings). The PER index is considered to be one of the most representative methods for relative valuation along with PSR. It presents how a company is currently valued in the market in terms of multiples of the earnings it incurred.
Issue of Calculating “Cost” in DEX Protocol Valuation
While the PSR index uses revenue as its denominator for the calculation, the PER index uses “Earnings.” In the simplest term, earnings is the variable you get from subtracting the cost of sales activities from the revenue. However, unlike any other companies in the real and tangible world, DEX protocols operating via preassigned codes do not have any sales activities nor any tangible “cost” per se. As such, there is the issue of how the “cost” will be set for the purpose of evaluating DEX protocols using PER index.
Transactions that occur on DEX protocols, or “token swaps,” are based on the liquidity provided by liquidity providers (LPs), and the transaction fees incurred are distributed among LPs and protocols in general. In other words, transaction fees paid to LPs can be considered a cost for DEX protocols in the sense that a portion of the transaction fee is paid to LPs as a small “incentive” of sorts for the liquidity required to run DEX protocols. Therefore, the earnings variable for PER valuation calculation can be set as “total revenue” after subtracting “LPs’ cut of the transaction fees.”
How Each Protocol Calculates Their Earnings
- Uniswap: As Uniswap currently distributes 100% of transaction fees generated on the protocol to LPs, no earnings are incurred. However, they left open the possibility of levying 1/6 of their transaction fees as a protocol fee going forward via governance (as of Uniswap V2). As such, we can estimate their PER assuming the said governance is passed and adopted.
- SushiSwap: Earnings for SushiSwap are set at about 16.7% of their total revenue since they distribute 0.25% of their 0.3% transaction fees to LPs.
- PancakeSwap: Earnings for PancakeSwap are set at 32% of their total revenue since they distribute 0.17% of their 0.25% transaction fees to LPs.
- dYdX: This orderbook-based futures trading DEX does not have any portion of their revenue given to LPs. As such, their earnings are set as 100% of their total revenue.
- Curve Finance: Earnings for Curve Finance are set at 50% of their total revenue since they distribute 0.15% of their 0.3% transaction fees to LPs.
- Balancer: Balancer distributes 100% of their transaction fees to LPs, just like Uniswap. However, they left the possibility open for levying 10% of transaction fees as a protocol fee via governance going forward.
- Bancor: Earnings for Bancor are set at 50% of their total revenue since they distribute 50% of their transaction fees to LPs.
Each protocol’s PER calculations based on their earnings calculated as above are shown below:
Much like the PSR calculations, the PER results as above can be obtained for the companies in the peer group via earnings-based calculations, with the average PER for the whole peer group at 13.23, which is set as the fair PER.
With the fair PER as the standards, we can find that dYdX, SushiSwap and PancakeSwap are undervalued, and the rest of the DEX protocols slightly overvalued in the market. Below results were derived through PER valuations.
4. Key Assumptions for DCF Valuation
The DCF (Discounted Cash Flow) is an absolute valuation method that calculates companies’ value by converting their expected future profits into present value. DCF valuation can be utilized to evaluate DEX projects since they also generate revenue and profit. However, the key assumptions below need to be considered for the calculation.
1) Revenue & Profit Estimates (5 years)
The DeFi market grew close to a 13-fold based on revenue in 2021 against 2020. Given such a rare growth at a super-fast speed, it is deemed inappropriate to base their estimation on such a growth rate. As such, the growth rate was calculated as below, based on the share of the market that can be eaten up by the DeFi market going forward. It was assumed that virtual assets would take over 5% of the stock market in 5 years by 2027, and that the annual growth rate would decrease in a linear manner.
2) Terminal Growth Rate
The terminal growth rate to be applied post the 5-year revenue estimation is calculated as per the assumptions below. While it is common to apply a 0~2% terminal growth rate for listed companies, 4% may be applied to fast-growing stocks such as Tesla. Although the DEX sector is expected to show such fast growth, a lower rate of 3% was applied for this calculation, given the various risk factors such as regulations and open-source competition intensifying.
3) Discount Rate
Financial management textbooks will tell you to use WACC (Weighted Average Cost of Capital) to get the discount rate. However, arbitrary discount rates are sometimes applied on a working level where it is difficult to obtain specific values such as Beta. According to KPMG, 50% or even higher discount rates are applied to startups in the seed stage, and 20~30% discount rates are applied to startups in later stages, including those nearing IPOs. Considering how most of the projects we seek to evaluate here hold over $500 million in market cap and are listed on multiple exchanges, it was deemed fitting to consider them in their late stages. However, a rate of 30% - a figure at the higher end of the discount rate range – is to be applied, given that token projects’ annual inflation comes to about 5~10%.
5. DCF Valuation
Each DEX’s DCF valuation calculated with the assumptions mentioned above produced the following results:
As for Uniswap, it was assumed that 1/6 of transaction fees (0.05% of transaction value) is distributed to UNI token holders with the governance proposal passed, as mentioned earlier in the PER methodology section. (There is no fee provided to token holders currently.) In this case, the fair value of the Uniswap token is found as below:
The result yielded that the fair value of the Uniswap token is $10.1 and that it is currently about 10% overvalued (at $11.16). Since valuations for SushiSwap, PancakeSwap, dYdX, and Curve were all carried out under the same assumption, only the characteristics specifically considered in valuating each DEX will be mentioned from here on, starting with the next section on SushiSwap.
SushiSwap also provides 0.25% of their 0.3% transaction fees to LPs, as with Uniswap, and pays the remaining 0.05% to xSUSHI token holders who have staked SUSHI. (Please refer to “SushiSwap XCR”).
With SushiSwap’s fair value as per DCF calculation at about $10.5, it is found to be significantly undervalued at the moment (TP upside: 142%), showing a starkly different picture compared to that of the Uniswap token. Such discount seems to stem from various factors, including i) a smaller trading volume than Uniswap, ii) 0xMaki leaving the leadership, and iii) the controversy with 0xSifu of Frog Nation. However, in case the governance proposed by 0xMaki about a week earlier calling for the connection of Stargate cross-chain protocol to SushiSwap is accepted, SushiSwap will be equipped to provide liquidity to the 16 L1 blockchains supported by Stargate. If the proposal does get approved, it is expected to resolve the discounting factors and increase the value of SushiSwap.
PancakeSwap is different from Uniswap or SushiSwap in that their 0.25% transaction fee is comprised of 0.17% for LPs, 0.03% for Treasury, and 0.05% for CAKE buy-back and burning. Out of these, revenue for LPs and Treasury were deducted as cost before calculating FCF. Treasury revenue was counted out as the wallet for this is currently used to pay for the project’s operating costs, including costs for employee payroll, smart contract audits, bug bounties, and marketing.
The PancakeSwap token’s fair value as per DCF calculation is at about $11.89, which is undervalued, much like in the case with SushiSwap. (TP upside: 36%). The market considers their discount to stem from: i) the fact that this is a BSC chain project and ii) it has a very high inflation rate (+50%).
The dYdX is a futures DEX based on a hybrid protocol scheme (off-chain order relay, oh-chain settlement) using orderbook methodology rather than AMM, meaning that there is no payment attributed to LPs. As such, the entire revenue can be counted as their profit.
The dYdX token’s fair value as per DCF calculation is at about $99.18, which is a whopping 1,421% over the target price upside. However, for dYdX, token economics must be taken into consideration since their market capitalization against FDV (Fully Diluted Valuation) is very low, with only a small volume of their token currently in circulation. (Circulating supply: about 65,500 dYdX vs. total volume issued: 1 billion dYdX). If the calculation is based on the total volume issued rather than the circulating volume, their current price seems pretty fair. This shows that the market is evaluating dYdX using FDV rather than their current circulating supply. (Current price of $6.25 vs. Intrinsic value of $6.50).
Curve Finance provides 0.15% of their 0.3% transaction fees to LPs and the remaining 0.15% to veCRV token holders. When it is run in the DCF model with such specifics taken into consideration, the result is as below:
The Curve token’s fair value as per DCF calculation is at $1.8, which is about -38% against their current value. However, it should be noted that the CRV tokens issued as daily gauge rewards (i.e., bribing) and liquidity mining incentives (630 thousand a day) have not been included in this valuation for Curve. Even if the revenue incurred from the bribing is taken into consideration, given the massive volume of CRV tokens issued every day in the name of liquidity mining incentive, Curve is estimated to be in the reds substantially. It clearly shows that the high expectation held for Curve Finance, as they exert a powerful influence in the DeFi ecosystem, has been translated into an added premium put on their token price.
6) DCF Summary
The valuation of the five representative DEX tokens using the DCF model can be summed up as below:
- Undervalued: SushiSwap, PancakeSwap, and dYdX (as of circulating supply)
- Fairly Valued: dYdX (as of FDV)
- Overvalued: Uniswap, and Curve Finance
6. PTR - ROT Ratio
PTR (Price to TVL Ratio) - ROT (Revenue on TVL) index is a novel index developed by Xangle, branching off the ideas from PBR-ROE in the traditional financial market. TVL is short for “Total Value Locked” and refers to the total sum of asset size locked in AMM DEXs in need of a liquidity pool. PTR calculates the size of market capitalization against TVL, while ROT calculates the size of revenue against TVL. In general, a larger TVL means a larger room for liquidity, which tends to lead to more trade volume and revenue value. However, at times, transaction volume generated is low and revenue small despite a high TVL. In such cases, their market cap may be relatively low. It would be similar to how we sometimes find a company with a low ROE is undervalued and has a lower PBR than its competitors.
While you may not be able to use this index to get an absolute valuation, it does provide a certain basis that can be used to determine whether a specific project is relatively undervalued against TVL’s effectiveness. For example, when referring to the chart below, you can determine that SushiSwap located below the trend line signifies that it is undervalued. It means that despite their relatively high TVL effectiveness with ROT at 0.1, their market cap is low. On the other hand, Bancor is placed above the trend line as they have a large market cap compared to their low TVL effectiveness.
7. DEX Can Be Explained via Existing Valuation Tools
It felt like a breeze for us to go through the valuation for decentralized exchange (DEX), as the third part of the “Xangle Valuation Series” following ① Bitcoin and ② Ethereum, because being able to apply valuation methods that are already widely applied for traditional assets such as PSR, PER, and DCF made it easy to get into the discussion of valuation itself. Unlike Bitcoin and Ethereum, which needed first to be redefined and interpreted as something comparable to digital gold and internet infrastructure, respectively, before diving in, the business model for DEX is relatively straightforward that it was possible to approach the topic from the aspect of similarities it shares with the existing exchanges and securities firms for valuation.
In a nutshell, this is what DEX valuation is: Transactions between tokens are mediated (although there is no such intermediary body); the transaction fee incurred is recognized as revenue and shared with the token holders after giving a certain portion of it to the liquidity providers; and then, this last part is recognized as the earnings as well as the cash flow for token holders for the valuation. Xangle Valuation Series: ③ Decentralized Exchange (DEX) has utilized methods that are easy for even the existing value investors to approach. We hope this article gave our readers yet another opportunity to break away from the misunderstanding and misconception that virtual assets do not hold any intrinsic value.