How can you tell when an NFT is too expensive? What is the intrinsic price? Is there such a thing? Valuation of any asset is not an exact science and this is more relevant than ever in NFTs. So what we are going to do is break it down into a couple of sub topics in the table of content below. However, I would recommend that you read the introductory blog here first.
What we will be exploring in this two part blog:
What is Speculative and Intrinsic value?
First and foremost, let’s examine what I am attempting to coin here as speculative vs. intrinsic value for an asset. Intrinsic value is the long-term utility of an asset, for example, the discounted value of the future cash flows of a company, like dividends. Speculative value on the other hand is the belief that an asset will have value because everyone else believes it will have value. This belief can be price momentum driven (“bitcoin is increasing in value so people must believe in it”) and/or some ‘surface’ level interpretation about fundamentals (“bitcoin’s adoption is increasing so people will buy more of it”). Speculation is generally driven by market supply and demand dynamics, whereas intrinsic value, by the long-term realization of a utility.
An example of a speculative asset is gold. Gold is a safe haven, store-of-value asset, but it doesn’t provide any income or have significant utility (i.e. its usage in electronics is tiny relative to the total available supply; wearing gold jewelry is not a utility that gives gold value – it’s the other way around). Yet it derives its value primarily because society has believed in it for millenia. It isn’t that one value is good or bad in relation to another – they are just different.
Naturally, the above principles apply to the NFT asset class as well. We will attempt to examine NFT value from both perspectives; speculative – why a community’s belief gives it value, and intrinsic – tangible value in the form of utility. Word of caution – do remember that the subcategories we discuss can at times display a blend of both the above aspects.
One more note before we dive in – a lot of the discussion below is going to be centered on NFT collections that are trading on the secondary market. We are hoping to cover primary NFT collections for a different blog.
To summarize again, when an asset’s price is determined by the belief of a subset of investors and not by any income or utility provided by that asset, this value is speculative. Thus our goal here is to narrow down how we quantify and measure this belief.
General Market Conditions
This is a tricky one to bracket into any one of the speculative vs. intrinsic value categories. Overall market conditions can affect both speculative value and the intrinsic value of assets, including NFTs. For the moment however, we have classified this as part of speculative value since we are speaking here in the context of NFTs (which is still very nascent). NFTs are very much correlated to the cryptocurrency markets, and therefore by extension to economic fundamentals. Sudden changes in monetary policy (unexpected rate hikes) or sustained moves in the crypto market (which are also driven by economic conditions), have a strong impact on the overall NFT trading volume.
This impact is especially prevalent in more liquid, established secondary NFT collections (i.e. blue chips). The chart below analyses the movement of the price floor for given projects. The price floor is the lowest price for an NFT in a given collection. It acts as the threshold benchmark for demand for a collection. You can see how the globally precarious conditions in 2022 that caused the slide in Bitcoin also affected the NFTs floors of the largest collections.
The flipside of this is that in the long-term, a healthy economy also contributes to the steady proliferation of NFTs and their use cases, subsequently affecting the potential utility, and hence, the intrinsic value of some collections.
Price Momentum and Hype
Price trends and hype are generally self-reinforcing mechanics. Increased marketing exposure and virality in a project means more (short-term) demand, which means sustained upwards price action which in turn creates more virality, and so on. This is a quintessential form of short term speculative value. Moreover, NFT projects display very similar patterns of these ‘hype’ cycles, albeit to varying degrees. Projects (that survive) tend go through a distinct curve similar to that of the Gartner Hype Cycle, where there is a period of;
i) incubation – team setting up the project
ii) explosive growth
iii) inflated expectations – i.e. the ‘hype’
iv) inevitable bursting of these expectations
v) long-term sustained value creation (i.e. intrinsic value creation)
To illustrate the point, we randomly picked 5 NFT collections which have had a traded volume of ~$40-100MM. On the logarithmic chart below, you can see many of them experiencing stages i. to iv. above. Often, projects that fail to capture a sustained hype cycle see their collection volumes rapidly decline (more on this in our discussion about network effects below). Stage v) would take a lot longer than seen in the chart below, assuming the project even survives to this point.
Takeaway: Understand where in the lifetime of a project you will be entering, assuming this is a secondary market sale. If you are in a project for speculative value only – timing is everything.
The network effect is when the incremental addition of new participants increases the value of the existing network larger for all of the participants individually. In the TradFi world, this is why marketplaces, e-commerce sites, and social media experience disproportionate, ‘winner-takes-all’ growth. This is quantified well by Metcalfe’s law, which states that the value of a network is proportional to N^X (where N is the number of transacting participants and X is a constant). X is midway between 1-2. For example, BTC’s was estimated to be ~1.7 over its lifetime (i.e. every doubling of network participants increases total network value ~3.2x). The X constant is determined by the propensity to use a given network – the more individual participants contribute using a network the higher the perceived value.
Subsequently, it is important to understand who and how many are interacting with a project. A community of a collection should ideally have strong engagement, above average critical mass of participants (i.e. contributes to project liquidity), influencers, and followers.
Takeaway: Understand the reach and number of followers, active participants, and influential investors in a project to increase odds of success. Study the engagement and the trading volumes/liquidity.
In the next part we will explore how speculative value can be affected by attributes of supply. Please find Part II here