Why is the commonly used Price-to-Earnings ratio (P/E ratio) in the stock market considered ineffective in the cryptocurrency field?

In the stock market, the price-to-earnings ratio (P/E ratio) is a commonly used fundamental indicator, calculated by dividing the market price per share by the earnings per share to determine whether a stock is cheap or expensive. However, in the speculative nature of the cryptocurrency market, why does the concept of the P/E ratio seem to be less applicable?

This translation and summary is based on an article written by DeFi Education. The original article can be found here.

Explanation of P/E Ratio, Price-to-Earnings

"In the cryptocurrency market, the P/E ratio represents the ratio of token price to underlying protocol earnings, while in the stock market, it represents the ratio of stock price to earnings per share," DeFi Education stated.

People use the P/E ratio mainly for comparability. For example, if there are two companies, A and B, both generating $100 million in revenue through producing parts, which company would be a better acquisition target?

Assuming acquiring Company A costs only $300 million and Company B costs $500 million, with Company A having a P/E ratio of 3 and Company B having a P/E ratio of 5, acquiring Company A would be the cheaper option based on price. However, while the P/E ratio can provide a basis for comparison between companies, it overlooks important factors such as company debt, growth rate, and more.

DeFi Education believes that relying solely on the P/E ratio for comparison is too hasty, and the quality of earnings should also be considered. If a company has stable income, low risk, and is growing rapidly, it makes sense to trade at a higher P/E multiple.

After briefly discussing the concept of the P/E ratio, the next topic will be the pitfalls of using the P/E ratio in the DeFi space.

The Speculative Nature of the Cryptocurrency Market Affects the Relevance of the P/E Ratio

Since DeFi protocols heavily rely on speculative activities in the cryptocurrency market to generate cash flow, even if a dapp can quickly earn millions of dollars within a few months, it may ultimately end up with nothing.

"In traditional markets, the P/E ratio is the ratio of the current price to annual earnings, while in the crypto market, we see people annualizing the earnings of the last 30 days or 3 months by multiplying by 12 or 4 to calculate the annualized return, and then calculating the P/E ratio for comparison purposes," DeFi Education stated.

Due to the speculative nature of DeFi protocols, coupled with the ease with which other teams can fork and capture market share, the income is quite unstable. Therefore, basing annual benefits on short-term gains is not very informative.

The Complexity of Token Economics

Due to the unique economic structure of cryptocurrencies, they cannot be directly compared to stocks.

Compared to cryptocurrencies, stocks have a simpler structure where owning a stock represents owning a part of the company and earning profits from the company's cash flow. The main risks come from the company performing below expectations or diluting equity.

However, cryptocurrencies are not as straightforward as stocks. Besides being used for trading, they can also be used for voting on governance proposals, staking to earn additional income, and in some protocols, tokens even have direct utility value.

It is because of these reasons that comparing the P/E ratio in cryptocurrencies is more challenging.

The "E" in P/E Ratio

The "E" in the P/E ratio stands for earnings, which is income minus expenses.

In most token protocols, the biggest expense mainly comes from token issuance, where tokens are often used for some form of incentivized behavior, such as providing liquidity for the protocol.

Some argue that to calculate a token's most accurate P/E ratio, the cost of token issuance must be deducted, even if these tokens are created out of thin air by the protocol and do not incur any costs.

However, DeFi Education does not agree with this approach for the following reasons:

As mentioned earlier, DeFi Education believes that the P/E ratio is a flawed indicator, and in valuation and financial analysis, a company's intrinsic value, which is the "present value of future cash flows," is more important.

"Cash flow is a better measure, and if a choice has to be made between a somewhat accurate non-cash indicator or a totally accurate but non-cash indicator that excludes token cash, I would choose the latter," DeFi Education stated.

However, the issue then becomes how to account for token issuance.

DeFi Education states that for the purpose of P/E ratio calculation, it must be ignored. If the cost of token issuance is factored in during each P/E ratio calculation, it will result in many unusable numbers, negative values, or extremely high P/E ratios, rendering the indicator useless. Instead, the P/E ratio needs to be evaluated in conjunction with the token distribution schedule. If a protocol heavily relies on a large emission of tokens and can counteract selling pressure from token emissions, the cost of token issuance should be discounted or even ignored.

Additionally, besides the P/E ratio, DeFi Education believes focusing on the Price-to-Sales (P/S) ratio would be a better choice, even though it cannot reflect the importance of cash flow, it avoids the main problems encountered with the P/E ratio by ignoring expenses during calculation. However, in this case, a deeper understanding of the company's financial situation is required.

"The P/E ratio has significant limitations in the crypto space. When using it, be sure to understand these limitations and make appropriate adjustments. However, it is often preferred to ignore the P/E ratio and focus on other indicators," DeFi Education stated.

Note: The Price-to-Sales ratio is a vital reference data point in investment banking, calculated by dividing a company's market value by its revenue for the previous year or equivalently by dividing the company's stock price by its per-share revenue.