Author: Michael Nadeau
Original source:The DeFi Report
Compilation of the original text: The Way of DeFi
Author: Michael Nadeau
Original source:
Compilation of the original text: The Way of DeFi
This week, we share our current thoughts on the valuation framework for layer 1 blockchains, with a focus on Ethereum. Topics covered:
Tokens as instruments of capital formation
How ETH Fits into the Super Asset Class Framework
On-chain finance and discounted cash flow (Discounted cash flow) analysis
ETH as a digital commodity and store of valueOur Favorite KPIs to Monitor。
Why tokens are useful
We've covered token basics in detail before. If you are interested, you can go to
Find out more about Token Economics 101 here
To set the stage for this report, I would like to briefly reiterate why we believe tokens are a powerful bootstrapping and capital formation tool. If you are already familiar with this, you can skip this section.
Simply put, tokens are most useful when certain behaviors need to be incentivized in a permissionless manner among the general public. Tokens can help coordinate activities towards a shared, broad, decentralized goal.
Taking Ethereum as an example, its goal is to create a world computer or open data network that can leverage smart contracts, peer-to-peer interactions, and user-controlled data to power new Internet-based business models.
To steer its existence in an open-source fashion—with no individual or entity controlling access to (or editing rights to) the data network—Ethereum issued a token and programmed the blockchain to reward early contributors. Drawing on the success of Bitcoin, this creates the necessary incentives to help coordinate the actions of individual contributors and service providers around the world—developers, validators, node operators, miners, etc.Super Asset Class Framework
In traditional finance, we usually divide financial assets into 3 super asset classes:1. Capital assets:
Assets that directly generate cash flow. Bonds, real estate, and stocks all fall into this category.2. Consumable/Transformable Assets:
Assets that can be consumed or transformed, and that have economic value but do not directly generate cash flow. Examples include commodities such as corn, oil, or precious metals.
3. Store of value or monetary asset:An asset that does not provide an income stream and cannot be consumed or converted. Examples include currency, precious metals (money premium), art and collectibles.
How do layer 1 crypto assets like ETH fit into this framework? In fact, ETH has the characteristics of all three super asset classes.
Capital Assets:Ethereum generates cash flow—acquired by validators/block producers through user transactions, and income can only be obtained by holding native tokens and staking them into smart contracts.
*Note that holding ETH itself does not yield a yield - like a stock or bond that pays a dividend. Their ETH must be staked - validating transactions and providing services to the network - in order to earn rewards.Consumable/Convertible Assets:
Ethereum also has the characteristics of a commodity. ETH is "spent" as more and more people use the network. This functionality is programmed through a burn mechanism that functions like an automatic share buyback as demand for block space increases. Just like you need gas to operate vehicles and machinery, you need some ETH to use the Ethereum database or any application built on top of it. About 70-85% of the ETH you paid will be "burned" and removed from circulation. This is why some say ETH is like "digital oil". It has features that make it function like a digital commodity.
Store of value/monetary assets:
The perceived value of a store of value/monetary asset depends on the exchange rate and the perception of market participants. For example, if people believe that the U.S. dollar will experience higher-than-normal inflation over the next few years, they may want to hold gold instead of U.S. dollars. Or if they think the US is a more stable economy, they might hold dollars instead of euros.
People may hold collectibles or luxury art based on what the market thinks the value of these items is. In general, store-of-value assets need to be unique and scarce. Since the utility of Ethereum (the network) is likely to increase in the coming years while the supply of ETH (the asset) decreases, some market participants view ETH as a store of value.
Finance on the chain
Want to lend on Aave or trade on Uniswap? You will need to pay for block space. Want to mint or buy NFTs? Want to send some USDC to family? Want to play Ethereum-based games? You all need some block space.
Every transaction - recording data (not just financial) - must pay a block space fee. Users pay for block space using the native token ETH. Ethereum is a technology platform, and we can think of it like Amazon or Apple's iPhone. In addition to selling hardware, Apple's iPhone also makes money from developers building apps and putting them on the App Store. So if developers build interesting new businesses on the Ethereum platform that people want to use, the crypto asset that powers the platform, ETH, should generate economic value.
Let's break this down using a simple on-chain financial reporting framework:image description
Data: Token TerminalFee Revenue (Fee Revenue):
Refers to the total dollar value of block space sold during the period.Revenue cost:
Refers to the dollar value of fees paid to global service providers (validators). Last year, roughly 15% of fees were paid to validators — which equates to roughly 5.1% for validators today.Gross profit:
Refers to the total fees incurred minus the amount paid to the service provider/validator. This is also the total dollar amount of ETH burned - we should think of this as a share buyback benefiting passive holders of ETH. More on that later.Operating expenses:
This is the dollar value of the block subsidy (or protocol inflation) paid to service providers/validators globally. We can think of this project as Ethereum's security budget. After the merger it was reduced by 90%. *We'll note that the blockchain doesn't actually "pay" for anything here. We should think of it more like a startup issuing additional equity, diluting existing shareholders.Net income:
important:As long as the demand for block space exceeds the security budget, the network can be considered profitable - as the circulating supply will drop (in favor of passive holders). At the same time, validators (active holders) will receive considerable benefits from transaction fees.
There is theoretically no limit to the amount of ETH that can be "burned" or removed from circulation, as it is directly related to transaction volume. More transactions (demand for block space) = more ETH burned and removed from the market. However, there is a limit to the amount of ETH that can be issued. It is determined by the forward guidance of the Ethereum Foundation and depends on the amount of ETH locked in the staking/validator smart contract. Today, with 13.8% of circulating ETH locked in staking contracts, the network has an inflation rate of approximately 1700 ETH/day.
As long as the demand for block space exceeds the security budget, the network can be considered profitable - as the circulating supply will drop (in favor of passive holders). At the same time, validators (active holders) will receive considerable benefits from transaction fees.
We can see that this was the case last quarter despite the deep bear market in cryptocurrencies. When looking at the income statement, you might be wondering why blockchain has been relatively unprofitable over the past 6 and 12 months.
We can attribute the shift in profitability to the merger that took place on September 16th. Below we can observe the net new issuance of ETH since the merger.
image description
Data source: Token Terminal
The Ethereum Foundation Overpays Its Miners! This graph shows this visually. As mentioned, Ethereum has slashed its security fees by roughly 90% since the network switched to proof-of-stake (PoS).Capital Asset Valuation。
Due to the speculative and volatile nature of ETH - from a market value and usage perspective, we ran two different discounted cash flows.a. The total transaction costs in 2022, the average annual growth rate is 25%, the discount rate is 12%, and the period is 20 years. This brings us to a market cap of $416 billion or $3459/token fully diluted. Remember, these are bear market numbers, as fees are down 58% in 2022 compared to 2021.
Here is a simple DCF calculation
b. Total transaction fees in 2021, with an average annual growth rate of 25%. If we keep everything else constant and extrapolate annual revenue in 2021, we get a market cap of $966 billion or $8022/token. This gives us an idea for valuation using bull market data.
Here is a simple DCF calculation.
Ethereum has the potential to serve as a settlement layer for global finance with many other use cases. So the addressable market is very large. Viewed in this light, a $1 trillion market cap seems plausible.
Note that we used a fairly conservative average annual fee growth rate of 25%. Over the past 5 years, the real compound annual growth rate of Ethereum fee income has been 146%, including a significant decline of 58% in 2022.
These calculations are a starting point for a valuation analysis and should not be considered investment advice. The term, discount rate and average growth rate can be adjusted according to the needs of various scenario analysis. Using total transaction fees as our starting point may also have wrong assumptions. Finally, separate analyzes of passive holders of ETH (non-stakers) and stakers/validators may be required.
Revenue/Earnings Multiple
Because Ethereum is a decentralized network, its fees are borne by its distributed service providers/validators. These fees are essentially the consideration for the pledge, the dollar value of the ETH staked. As we noted in the on-chain finance section, network fees can also be thought of as protocol inflation/fees paid by the network to incentivize validator participation. Some analysts believe that network fees are a distraction and therefore should not be included in earnings multiple analysis or discounted cash flow analysis. In such event, the gross income will be considered proceeds.
To put that into perspective, if we multiply revenues over the past few years and compare them to today's market cap, we get:
2022: 41x revenue multiple or price/sales ratio
These numbers may be viewed as attractive, as a high-growth technology company may see higher earnings multiples. Tesla is an extreme example, trading at more than 200 times earnings during the 2021 bull market. Amazon currently trades at 86 times earnings and is currently down 45% from its peak share price.
daily traffic
image descriptionData: Etherscan
After the merger, we are issuing ~1700 new ETH per day, almost a 90% reduction! This number fluctuates slightly based on the total amount of ETH staked.
Main points:Remember, validators have no operating expenses. So 80% of the automatic new supply selling pressure is gone.
Finally, there are currently 18 million ETH locked in DeFi applications, add this amount to the 16 million ETH locked in pledge contracts, and we have roughly 28% of the circulating supply locked in smart contracts and earning yield. We can think of this as an "illiquid circulating supply".Main points:
The market must absorb the guaranteed daily selling pressure of approximately $16,000,000 before consolidation. That selling pressure has largely disappeared today. In fact, in the days when more ETH was burned than issued, structural "fund outflows" were needed to prevent price increases. We are in a bear market, but a quick look at Etherscan shows that issuance has been net deflationary on 11 of the 14 days so far in 2023.
We can observe traffic changes in recent market activity.
Ethereum sold off sharply in June 2022 (before the merger), bottoming at around $900. In November, we had yet another capitulation related to the FTX crash (post-consolidation) - when Bitcoin led the broader market to new lows. However, Ethereum is holding its ground. It didn't make new lows. In fact, its bottom was about 27% higher than the June low. We believe this is due to a structural change in traffic due to the September 16, 2022 merger.
The key for the Ethereum Foundation is to find a balance where ETH consumption exceeds ETH creation, but does not result in excessive transaction costs. After all, if gas prices rise too quickly, people will stop road trips. Or they seek other travel options. In the case of Ethereum, users may move to other blockchains. We think the cost/transaction will decrease over time (due to layer 2 solutions), but the transaction volume will increase with more adoption and use cases. Since transactions on L2 are ultimately batch-settled on Ethereum L1, this should lead to a low-fee but deflationary token supply — the best of both worlds.The commodity value of ETH is difficult to predict. It is based on speculation about supply/demand. We are based on the Ethereum Foundation's ETH mortgage rate and new issuance
Transparent policies or forward guidance to understand availability.
Requirements depend on what developers are doing. When it's easier to pay with stablecoins, when games are fun and allow users to own in-game assets through NFTs, when the biggest brands in the world issue NFTs and increase the experience of consumer loyalty, when social media allows users to control their Users will come when wallets and DeFi applications are easy to use, when KYC/AML pools are introduced and standards are created for smart contract auditing.
We think this will happen because of the benefits of an open network, superior user-centric business models, and user-controlled data.
Store of Value/Monetary Assets
ETH is a medium of exchange in the Ethereum ecosystem, and it is the grease that drives the blockchain. That said, when an asset is used as a medium of exchange, such as a fiat currency, it generally does not serve as a good store of value. However, based on the ETH token supply and demand structure outlined in this report, we believe the market is likely to assign a monetary premium to ETH.
key data points
There are many data points to track as we monitor the long-term viability of Ethereum and other blockchains. The following indicators provide the most signals during this phase:
Number of developers and developer growth
Data source: Token Terminal
Over the past 6 years, the compound annual growth rate of Ethereum developers has been 32%. We are monitoring the recent decline, but believe it is mostly seasonal. Interestingly, code commits have been flat for several years, down from earlier years. This is due to the power of composable open source code - each problem solved once, allowing others to build on top of it - a bit like Lego bricks linking to each other.
Number of active users and user growth
Data source: Token Terminal
Daily active users are currently around 400,000, and the growth is quite stable. Since 2016, users have grown at a CAGR of 92.9%, and since 2017, 38%. Subscribers in 2022 are down about 3% compared to 2021.
Data source: Etherscan
income
Despite the price drop, transaction volumes have held up well over the last year. The network is down 12% this year. Having said that, it has grown at a CAGR of 76% over the past 6 years and 32% over the past 5 years. As layer 2 scales, we start to see transaction growth in the base layer start to level off.
income
image descriptionData source: Token TerminalEthereum’s revenue figures remain strong. Over the past 30 days, the network averaged about $2.6 million in daily sales. The compound annual growth rate for the past 6 years is 454%. If we start with the more active 2017, the CAGR over the 5-year period is 146% - even with a 58% drop in 2022 vs. 2021.
It can also be manipulated like we saw with Solana last year
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