Why DCFs are illogical for valuing layer 1s
I often see analysts attempt to justify layer 1 token price targets by calculating the network’s discounted cash flow (DCF) for future transaction fees and staking yield. As an ex-TradFi investor I certainly understand the temptation. While I agree the analysis can be used for real world asset (RWA) yielding tokens (e.g. tokens with stablecoin dividends), I do not believe the math is relevant for layer 1 tokens.
Before diving in, its important to acknowledge that blockchains have a variety of different consensus mechanisms and economic designs, so generalized analysis may not always be accurate. This article focuses on PoS blockchains that pay validators/delegators with staking yield, and use transaction fees for token burns (similar to Ethereum’s design).
We use DCFs to value equity — why not L1 tokens?
Equity is a claim on a business’s cash flow, and therefore, investors agree it can be valued based on the present (discounted) value of expected future cash flow.
Native L1 tokens are used to secure the network through staking and as gas payments to process transactions. Stakers receive yield on their tokens, while gas fees are used to burn tokens, which lowers supply, and all else equal, increases the value of the remaining tokens. Therefore, many argue that because token holders benefit from both staking yield and transaction fees, valuation can be derived from the DCF of the two. However, I vehemently disagree with this logic. To understand why, lets dig a little deeper into staking yield and transaction fee dynamics.
Why staking yield?
PoW blockchains require compute power to secure the network. In an effort to increase energy efficiency, newer chains have adopted the PoS model which secures the network through token staking. Simply put, participants stake tokens to the network in a manner that disincentivizes malicious behavior. If a validator acts dishonestly, its stake gets slashed, thereby making it economically unviable to do so.
Just like PoW miners are compensated with block rewards for contributing to network security, stakers receive token yield for similarly contributing to security. In this lens, staking yield is nearly identical to stock-based compensation (SBC), the equity portion of employee compensation at a traditional company.
SBC is attractive for high growth companies since its more capital efficient than paying employees entirely in cash. Multi-year vesting schedules effectively push out company payments to the future for services rendered today. Similarly, blockchains bootstrap security by compensating validators with token rewards (effectively creating currency like companies do with equity), which is similarly more capital efficient than paying validators with cash.
The downside to both SBC and staking yield is asset dilution. Creating more equity shares/tokens reduces the value of existing equity shares/tokens. Companies combat this with stock buybacks — once the business is mature enough to generate consistent cash flow, it buys back stock to control equity dilution. So what about blockchains? This is where transaction fees come in.
Why transaction fees?
Blockchains charge gas (transaction) fees to use the network for two main reasons:
Prevent spam: If transactions were free, it would be easy for a malicious actor to overload the blockchain with spam and clog the network (DDoS attack). Transaction fees increases the cost to spam, discouraging nefarious behavior.
(Indirectly) fund network operations: Although operations are directly funded through staking yield, transaction fees work to offset the accompanying inflation through token burns (tokens used as gas are deleted). Most agree high inflation is troublesome — but high deflation disincentivizes token spend and also should also be avoided. Therefore, blockchains at equilibrium should generate enough transaction fees to roughly offset the inflation from staking yield.
Valuation implications
As previously mentioned, equity derives its value from operating cash flow. SBC and buybacks have nothing to do with equity value — they only impact the number of shares outstanding. Of course, all else equal, fewer shares = higher price per share, but SBC and buybacks only impact the denominator of the equation, not the actual value of the company. Moreover, one could argue using company cash for buybacks instead of investing in growth is actually detrimental to equity value and therefore neutral to price per share.
Similarly, staking yield and transaction fees only impact token supply, not the network value!
Therefore, using a DCF analysis for network fees & staking yield doesn’t reveal anything about blockchain value. In fact, I don’t believe it reveals anything insightful given they ideally cancel each other out to control token dilution (amount of fees & yield is irrelevant, just need to be similar in value for dilution management).
So what drives layer 1 network value? As I’ve previously argued, its value is derived purely from the demand to use the blockchain (link).
Photo cred: Investopedia