Real yield is an emerging trend in DeFi, taking inspiration from the concept in Traditional Finance (TradFi) but with some strong distinctions. During DeFi summer, many individuals had the opportunity to take advantage of yield farming - often lucrative APYs earned from protocols encouraging individuals to stake their native token by issuing their own token as interest. While incentivizing users to purchase and stake the token, it also had the opportunity to lead to rapid devaluation of the token itself through the increased supply exposing stakers to inflation.
In TradFi, real yield is calculated by subtracting the cost of inflation from the nominal returns, for instance, a bondholder may receive. In DeFi, real yield is the process of rewarding users of a token in another denomination, such as ETH or USDC. Real yield can be derived from a variety of use cases that currently exist within the DeFi ecosystem. These use cases include liquidity provision, token swapping, directional trading, borrowing and leverage trading, yield farming, staking, depositing capital, and securely storing crypto assets.
With interest rewarded to stakers obtained potentially through trading and transaction fees from the platform, it has the opportunity to incentivize staking while minimizing investor exposure to token inflation. As with any other innovation in a quick-moving environment, it doesn’t come without its own risks though.
Risks with Real Yield
Primarily, the borrowed term from TradFi could be misleading to new investors unfamiliar with the DeFi distinction as a project may have the opportunity to tout its real yield APY as a good protected investment while real yield itself doesn’t natively protect against token inflation. For example, while real yield directly accounts for inflation in TradFi, in DeFi, a project could reward stakers using dividends in the form of other tokens while simultaneously increasing the supply of their own and maintaining a high DeFi real yield. Unless the project simultaneously guarantees to reduce token supply increases, the staked tokens of the investor may still be exposed to inflationary loss.
Further, it could diminish the project’s long-term viability. Traditionally, young companies defer paying dividends to stakeholders and instead reinvest profits to grow themself and ensure a sustainable, successful corporation. As the majority of the projects in crypto are new, and still establishing their product, paying out dividends at such an early stage of a project’s life cycle has the opportunity to deplete its treasury. One done in Q3 2022, found that only ~six DeFi protocols offered real yield, and just two were doing so in a sustainable manner.So while real yield may show promise in the short term as a way to attract and protect investors, it also has the opportunity to diminish the long-term viability of a project.
Finally, borrowing a concept from TradFi may also make it clearer to regulators how to label different tokens. This could potentially lead to these tokens being labeled as securities, but would no doubt have an impact on the decision making. Regardless, real yield is an interesting recent development in DeFi that will be a player to watch in the projects that have already implemented it.
Now that we have established the types of yield a project can produce, we are now able to measure this return and begin to form valuation metrics. One such method is applying the concept of the price-to-earnings (P/S ratio) used in TradFi to blockchains. Investors can use this ratio to determine whether a blockchain is fairly priced by comparing its P/S ratio with blockchains of a similar function. For example, L1 blockchains can be compared with one another, as well as among dApps and between DeFi protocols. The P/S ratio is most suited for blockchains that are profit-seeking, such as DeFi protocols, which can earn high-interest income from user borrowing in the protocol.
Unlike traditional companies, blockchain protocols do not have shares, so we can manipulate some variables to create a more useable equation:
The fully diluted market cap, which we use for the P/S ratio, is conventionally calculated as the max supply of coins multiplied by the price. Total earnings represent the annual total revenue that goes exclusively to the protocol itself, which can also be defined as profit. A higher P/S ratio suggests that the project is more overvalued, while a lower P/S ratio suggests that the project is more undervalued.
This chart shows the P/S ratios of many major, leading L1 and L2 blockchains. These ratios are far higher compared to stocks in traditional markets. The average P/S ratio among these blockchains is far greater than the average P/E ratio of 29.1 for the S&P 500. All of these blockchains have a P/S ratio of over 100x, and more than half have a ratio of over 1000x. Cosmos sticks out with its extremely unusual P/S ratio of over 200,000. This is due to all the factors that affect the ratio. Cosmos has a very low annual profit, in the thousands, while its total token supply and price are very high, which means its market cap is high. Cosmos’s low profit and high market cap give it such a high P/S ratio.
The diluted market cap we use equals the max supply of coins and not the circulating supply. This means that, theoretically, protocols without a set max supply could have comparatively lower ratios and seem less overvalued because of their artificially lower market caps. For example, Ethereum has a P/S value of just 140.6, much lower than the other L1 blockchains. However, this correlation does not always hold, since Algorand also does not have a max supply but is relatively overvalued with a P/S of over 16,000.
Though the P/S ratio bridges the relatively new blockchain space with a more familiar stock market, it does not work perfectly for blockchains. Not all blockchains produce profits, such as Bitcoin, so these ratios cannot be used for all blockchains. In addition, revenues in blockchains are typically denominated in cryptocurrencies, which have historically been very volatile. The P/S ratio can be used to casually compare similar blockchains but should not be used as part of an investment thesis. The use case, roadmap, and management are more important qualitative measures to consider to better evaluate a blockchain.
The P/E ratio is defined as the market cap/protocol’s annual revenue (revenue = protocol fees earned). The only difference is that the denominator for P/E (annual revenue) includes revenues that go to token holders, rather than just LPs that are yield farming. If all revenue goes to the protocol, then the P/S ratio will be the same as the P/E ratio. Investors can compare these ratios between different blockchains to determine how appropriate the price of the protocol and its tokens are, relative to its total revenue.
One final metric used to determine the value/profitability of a DeFi protocol is the Protocol Average Revenue Per User (PARPA). As the name suggests, it is “An indicator of the profitability of a protocol based on the amount of money that is generated from each of its users.” As the table below shows, there is a wide distribution among DeFi protocols, with yield aggregators such as Yearn and Convex boasting ~10x the revenue per user compared to DeFi stalwarts Maker and Curve.
