Mastering the Art of Token Valuation: A Step-by-Step Guide

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mins read
October 16, 2023
John

Valuing token economies can be challenging, especially for those new to cryptocurrency and decentralised finance (Defi). Understanding the value of a web3 ecosystem isn’t just helpful for players and investors looking to allocate capital. Understanding the true value of a token is crucial for developers of decentralized applications (dApps) to create a sustainable business model and drive growth. By understanding the token's value, developers can create clear pricing for goods or services within the dApp, providing a steady revenue stream to support the dApp's development and maintenance. Additionally, a clearly defined token value can attract and retain users, leading to increased adoption and engagement, which in turn drives the dApp's growth. A well-designed tokenomics model, which governs the issuance, distribution, and circulation of tokens in a dApp, can also ensure the long-term sustainability and growth of the dApp.

In this piece we will explore a method for valuing DeFi Protocol tokens, digital assets used in DeFi systems.


[Time-poor? Need the TLDR? Skip to the bottom for a summary].

This approach, outlined in the research report "De-Fi Protocol Token Valuation by Projecting Token Flows and Estimating an Appropriate Risk Premium," involves forecasting future token flows and estimating an appropriate risk premium based on the specific characteristics and risks of the protocol.

Before diving into the valuation process, it's essential to understand what DeFi Protocol tokens are and how they are used. DeFi protocols operate on blockchain networks and allow users to access various financial services, such as lending, borrowing, and trading, without the need for traditional financial intermediaries. DeFi Protocol tokens facilitate these transactions and can be bought and sold on cryptocurrency exchanges. Some Web3 games enable similar mechanics; this valuation model can be applied to a broad range of decentralised assets.

The three primary protocol tokens are security, governance, and reward/utility tokens. Security or governance tokens give the holder a say or equity in the platform. For example, a token offered by a decentralised game may pay dividends to its holders from the game's earnings. Reward tokens, on the other hand, are used to reward users for investing in and using the platform. These tokens are commonly found in DeFi products such as swaps, crypto-collateralized lending and borrowing services, Web3 games, and yield farms. It is worth noting that a token can fulfil all of the above roles in a protocol.

Now that we have a basic understanding of DeFi Protocol tokens, let's delve into the process of valuing them.

It is important to consider the token's utility to forecast future token flows accurately. In traditional economics, value is derived from the utility, which is valid for tokens. A token with a clear and valuable purpose is more likely to have value in the market. For example, a reward token that incentivises users to participate in a decentralised lending and borrowing platform may have strong demand and utility, leading to a higher valuation.

In addition to considering the token's utility, it is also essential to consider the token distribution when evaluating a DeFi Protocol.

In addition to considering the token's utility, it is also essential to consider the token distribution when evaluating a DeFi Protocol. The token distribution, or how the tokens are distributed among holders, can significantly impact the token's long-term value. A fairly distributed token, with wide distribution among holders, is more likely to have a healthy and stable ecosystem. On the other hand, a token with a narrow distribution, concentrated among a few holders, may be more vulnerable to manipulation and could have a lower valuation.

Another critical factor to consider when evaluating a DeFi Protocol is the risk premium, or the additional return investors require to compensate for the specific risks associated with the protocol. These risks may include liquidity, market, or other types of risk specific to the protocol. When evaluating the token's potential value, investors can consider these risks by estimating an appropriate risk premium.

It's worth noting that the process of valuing DeFi Protocol tokens is complex and requires a thorough understanding of the specific use case and the market dynamics at play. While the valuation equation provides a valuable framework for evaluating the potential value of a DeFi Protocol, it is just one tool in the toolkit of a token engineering expert. Other factors to consider include the protocol's development stage, the market competition, and the regulatory environment.

Traditional valuation methods need help to accurately assess the value of crypto assets due to token economics' unique and complex nature. These models can become obsolete as tokenomics change, and it is difficult to determine the total addressable market for these emerging technologies. Additionally, limited data history and the irrationality of the still-maturing crypto market make it challenging to determine the value of crypto assets accurately.

One method for valuing DeFi Protocols is the equation developed by ULU Ventures, a Palo Alto-based VC firm. Their model consists of four pillars, which outline the principles for determining the value of crypto assets.

  1. The first pillar states that value should represent long-term, intrinsic value rather than short-term volatility.
  2. The second pillar says value should include a liquidity risk discount based on objective measures.
  3. The third pillar states that value should be comparable with the value calculated for any other startup investment, considering factors such as fund fees and taxes.
  4. The fourth pillar states that value should be based on a consistent set of considerations, ensuring that the valuation method remains constant over the asset's lifespan.

Using this formula, ULU Ventures determines the value of a crypto asset using the following equation:

Where Av is the asset value, C is the asset's initial cost, Wtp is the weighted average token price, r is the discount rate for liquidity risk, t is the tax rate, and Tq is the number of tokens. This equation considers the asset’s initial cost, the token's weighted average price over a fiscal quarter, the discount rate for liquidity risk, the tax rate, and the number of tokens in the calculation. By using this equation, investors can more accurately evaluate the potential value of a DeFi Protocol token and make informed decisions about their investments.

It's important to remember that the process of valuing tokens is complex and dynamic, and the equation provided by ULU Ventures is just one approach. Different firms and institutions may have their methods and techniques, and investors must conduct their own due diligence and consider various factors when evaluating a crypto asset's potential value. At Acxyn, we have developed our own methodology for valuing video game economies and will share more information in the future.

"People win Nobel Prizes for that kind of thing." Chris Burniske

We initially start by scoring games based on a broad range of metrics, which allows Acxyn to more accurately identify the risk of investing in tokens and determine the discount that could be applied to a valuation framework.

Leveraging the Acxyn scoring system, investors can make more informed investment decisions. It will also play an integral part in developing an Acxyn index of assets, the tokenisation of IP for video game developers and building sustainable DeFi applications tailored to the video game industry. On-chain transparency, secure investment opportunities via smart contracts and robust valuation frameworks will power the future of investability into new asset classes and drive commercial opportunities for video game developers in the Acxyn ecosystem.

Acxyn will constantly strive to bring the most reliable valuation model to the market. The successful development of a reliable method for valuing crypto assets can bring great financial success to its ecosystem and possibly even recognition in the form of a Nobel Prize. As Chris Burniske noted in 2017, "People win Nobel Prizes for that kind of thing.”

In conclusion, valuing DeFi Protocol tokens involves forecasting future token flows, considering the utility and distribution of the token, and estimating an appropriate risk premium based on the specific characteristics and risks of the protocol. By following these principles and using a consistent and transparent approach, investors can gain valuable insights into the potential value of a token and navigate the exciting but complex world of cryptocurrency, #GameFi and #DeFi.

TLDR:

Understanding the true value of a token is crucial for developers of #decentralized applications (dApps) building web3 game economies to create a sustainable business model and drive growth. By understanding the token's value, developers can create clear pricing for goods or services within the dApp, providing a steady revenue stream to support the dApp's development and maintenance. Additionally, a clearly defined token value can attract and retain users, leading to increased adoption and engagement which drives the dApp's growth. A well-designed tokenomics model, which governs the issuance, distribution, and circulation of tokens in a dApp, can also ensure the long-term sustainability and growth of the dApp. This blog post explore a method for valuing DeFi Protocol tokens, digital assets used in DeFi systems, and the process of valuing them.


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