Crypto Yield

Does it even make sense?

A token’s yield is a simple heuristic that is gaining adoption. Yield describes the income generated from an investment. For example, ETH staking yields 6%. If you buy and stake ETH, you will get 6% more ETH per year. 

Yield is a helpful shorthand. Simple heuristics work. They help people understand an asset's value. But the yield mechanics are more complicated than the simple heuristic suggests. And the shorthand has its shortcomings. 

I explain how the yield mechanics work, their limitations and what to make of crypto yields…spoiler they’re misunderstood. This article is part of a broader study on valuing crypto assets including Crypto DCF (Non)-Sense, Does Value Exist in Crypto?, So Why Are Blockchains Valuable? 

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Simple heuristics work 

At a 6% yield, ETH trades at 16x earnings multiple (1/6%). A multiple is the reciprocal of the yield. Multiples and yields are two different ways of expressing the same thing. A 6% return per year means you will recover your initial investment in 16 years; hence a 16x earnings multiple. 

In the case of Ethereum, the 16x earnings multiple has gained traction because:

1. TradFi gets it: Earnings multiples and yields are part of the TradFi investment parlance. Stocks are discussed in terms of earnings multiples. Bonds and real-estate are compared in terms of yields. Ethereum trading at 16x earnings makes sense to TradFi investors.  

2. ETH comps well: At 16x earnings ETH looks attractive. It has arguably one of the largest total addressable markets. Its revenue growth is volatile but has a large potential. The S&P 500 trades at 23x earnings and has averaged above 20x since 1990. Tech darlings like Alphabet trade at 23x and historically, like Meta, Amazon, Netflix, traded at 30x and well above.    

Yield mechanics  

To generate a yield, protocols pay out some form of income to token holders. The income paid by the protocol comes from:

1. Token issuance / staking: The most common ‘income’ comes from token issuance. Protocols issue new tokens to validators to secure the network. The value of these new tokens are revenues for the validator that offset their costs and enable them to generate a profit.  

2. Transaction fees: Transaction fees are paid to validators for executing transactions. Transaction fees are not always paid to validators. In cases when they are, validators benefit from increased activity on chain. 

3. Burn: Tokens are removed from circulation. Although this is not an income paid to validators, reducing the number of tokens in circulation, all else being equal, increases the dollar value of the token. 

Maximal Extractable Value (“MEV”) is a fourth form of income validators can generate. MEV is additional income a validator can earn by opportunistically arranging the order of transactions.  

The table below details the three income streams Ethereum validators get from the protocol plus the additional MEV income. 

See model here.

Ethereum staking looks compelling. Validators generate a 6% yield, which equates to buying ETH at 16x earnings. 

The methodology is simple, understandable by investment practitioners and makes ETH look like a great buy. 

But the methodology has its shortcomings…

Yield shortcoming

Earnings multiple and yields are not tied to the underlying dollar token price. 

A stock’s earnings yield and multiple change when the stock price changes. ETH’s earnings yield and multiple does not change when ETH’s dollar price changes. 

A stock’s earnings multiple is the stock price divided by the company’s annual earnings (and the earnings yield is the earnings divided by stock price). All else being equal, the lower the multiple (and inversely the higher the earnings yield) the more attractive the stock is as an investment. It’s cheaper. As the stock price goes up, and earnings stay constant, the multiple increases (and the yield declines). The stock is then more expensive and a less attractive investment. The stock price directly impacts the earnings multiple and yield. 

As the ETH price in dollar increases or decreases, the ETH multiple stays at 16x. If nothing but the ETH price changed and catapulted to $10,000 or cratered to $100, ETH would still trade at 16x earnings. 

Wait….what? 

The ETH price in dollars has no impact on the ETH earnings multiple. So if I bought ETH at today’s price on the premise that it's cheap at 16x earnings and ETH rocketed to $10,000 or plummeted to $100, you could make the same argument at $10,000 and $100 that ETH is cheap trading at 16x earnings. 

That doesn’t make for a useful metric. 

Earnings multiple and yield are not driven by the dollar token price. It’s driven by the amount staked. All else being equal, the more staked, the higher the multiple (and the lower the yield) and vice versa. If 90% of ETH was staked, all else being equal, Ethereum would trade at 56x earnings, a 1.8% yield. If 5% of ETH was staked, all else being equal, Ethereum would trade at 8x earnings, a 13% yield. The staking rewards are inversely correlated to the amount staked. The more is staked, the lower the rewards. Mathematically, two things occur to reduce the yield. Staking income in the form of new tokens issued declines. Economic incentive to attract more validators is not needed. There are enough already. Simultaneously, the amount of ETH staked increases. The result is a smaller numerator (new tokens issued) and a larger denominator (total ETH staked) producing a smaller yield.   

Shady projects have additional shortcomings to their earnings yield and multiple. They are:

1. Vapor income: If you’re getting paid an ‘income’ in a token from a protocol that doesn’t actually create any value, it doesn’t matter how many tokens you’re paid; they’re worthless. If I created Clarity Protocol and I paid validators so many Clarity Tokens they earned a 50% yield, that doesn’t make Clarity Tokens valuable. That’s magic internet money. That’s what yield farming was. Buy our tokens, maybe do something, most likely do nothing, and we’ll give you more tokens. It’s predicated on the Greater Fool theory. A greater fools will see the sky-high yields and buy the token. Token price up. Dump your bags. 

2. Dilution: The yield generated needs to factor in the cost of dilution. Protocols face massive dilution (often called token inflation) because income is paid in the form of new tokens. As more tokens are issued, the value of each token in dollars declines. Think of it like a company paying all its expenses by issuing equity. The dilutive impact eventually destroys the equity value. Recently crypto has awakened to the concept of ‘real yields’, which is the yield generated minus the cost of dilution…duhh. That’s like a company ignoring the dilutive impact of paying all its employees exclusively in equity then claiming it has no salary expense.  

3. Staking masquerading as lockup: Validators earn income for securing and processing transactions for a blockchain. They stake their tokens to do so. Shady projects market to their token holders to ‘stake’ their tokens in exchange for more tokens. But their idea of staking doesn’t require validating. In reality, what they’re actually asking you to do is not to sell the token for a period and in exchange they’ll give you more tokens. It’s a pump and dump scheme. 

So how to think about crypto earnings yields / multiples?

Crypto earnings yields / multiples are intuitive. I invest X amount and I get Y in income annually. They work in a world that’s denominated in the native token. 

But we don’t live in that world. 

People think of ETH and other crypto assets in dollar terms. Transaction costs are converted into dollars. Validators incur costs in dollars.  

The yield / multiple approach values ETH in ETH. But that doesn’t tell you much. It’s like trying to value the Apple stock in units of Apple equity. The value of Apple only makes sense in dollars (or another unit of value). It’s like trying to value USD in USD. The value of the USD is relative to another currency like USD/EUR, USD/CAD, USD/GBP…you never see USD/USD because that doesn’t mean anything. 

Crypto maxis attempt to operate in a BTC, ETH, ATOM, SOL, pick your token denominated world. But none of these assets have an independent value. They all need to be valued in something else. The easiest ‘something else’ is USD. Their tokenomic models are all predicated on the value of their native token increasing relative to something else (ie USD). These chains all have a similar tokenomic model. Issue a lot of tokens initially to validators, early adopters and builders. Issue fewer tokens later on. That only works if ‘later on’ their token has gone up significantly in value. That way you’re willing to validate or build today for 1 token for what you previously needed 100 tokens to do because the token value has increased by 100x. If that doesn’t happen, you’re going to stop validating and building on the chain because you’re getting paid in an asset whose value keeps declining due to dilution. That 100x increase needs to be relative to something…to USD. So as much as blockchains are trying to distance themselves from USD, their models are dependent on a USD valuation.  

So where does that leave us?

If you live in an ETH denominated world, ETH trades at 6% yield (16x earnings). But if you don’t, ETH doesn’t really trade at 16x earnings. At least not like the S&P trades at 23x earnings. The 6% yield is helpful to understand the income return, but it can’t be compared to a bond yield or an earnings multiple. A token yield is divorced from the token’s dollar price, whereas TradFi yields change to reflect the change in the asset’s dollar price. Yet both TradFi and crypto assets are reliant on their respective asset values to increase in dollars.

Stay curious.

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