What do Bored Apes, Axie Infinity characters, and a parcel of LAND in Decentraland have in common? They're all examples of non-fungible tokens (NFTs) representing the ownership of a digital asset.
The NFT market surpassed $40 billion in 2021, according to Chainalysis, with no signs of slowing down in 2022. In addition to iconic collections, like Bored Apes and CryptoPunks, Christie's and Sotheby's have sold millions of dollars worth of NFTs, including the $69 million sale of Beeple's Everydays: The First 5000 Days in March 2021.
Unfortunately, investors that want to dip their toes into the NFT market face several hurdles. Purchasing and storing NFTs can be technically challenging for some, and more importantly, most people don't know how to value the nascent digital assets. After all, there's no physical item like a conventional collectible or cash flow like a bond.
Let's look at how NFTs work, why you might invest in them, and the valuation techniques you can use to make informed decisions.
NFTs became a $41 billion asset class in 2021, but many investors don't know how to value digital collectibles.
A Brief NFT Primer
Non-fungible tokens, or NFTs, are unique tokens on a blockchain that prove ownership of a one-of-a-kind digital item. Contrary to what many believe, though, NFTs don't contain any actual artwork or digital assets. Instead, they contain a reference to a digital asset, such as a link to a piece of digital art hosted on the Interplanetary File System (IPFS).
In essence, NFTs are contracts or agreements between an artist and a collector. The terms of these agreements vary on a case-by-case basis. For instance, an artist might retain copyright and reproduction rights as with physical art collections. Or, in some cases, NFTs may only give owners personal, non-commercial rights to the artwork.
Most NFTs are bought and sold on NFT marketplaces. The most popular NFT marketplace is OpenSea, which has over two million collections containing over 80 million NFTs with over $20 billion in transaction volume. And, of course, non-artistic NFTs typically have proprietary platforms, such as Axie Infinity's characters or Decentraland's LAND parcels.
Anyone can purchase an NFT by setting up a wallet like MetaMask and connecting the wallet to an NFT marketplace. For example, you might fund a wallet with ETH, connect the wallet to OpenSea, and purchase an NFT with ETH. The NFT will appear in your wallet, where you can use it to authenticate (e.g., the BAYC) and store it as a collectible.
Why Invest in NFTs?
You might invest in NFTs for the same reason as any other collectible. While anyone can copy a Bored Ape image, there's nothing to stop someone from counterfeiting a piece of fine art or reproducing a rare baseball card. The value comes from the idea of ownership more than the physical medium. NFTs are simply digital-native collectibles.
NFTs provide these several benefits over physical collectibles:
- Liquidity – NFTs are much easier to swap than physical pieces of art or other collectibles. You don't have to worry about sending items via mail and insuring them against damage or loss.
- Extensibility – NFTs are smart contracts with tremendous flexibility. For instance, an artist may include code that gives them the right to a certain percentage of secondary sales.
- Diversity – NFTs can represent just about any form of art or collectible item. For instance, they could describe a plot of real estate, a piece of fine art, or even a personal avatar.
Of course, there are several downsides, too. Consider:
- Security – NFTs are digital-native collectibles, making them much easier to steal than physical collectibles. For example, a piece of malware or a clever scam could result in an NFT's loss.
- Scams – The digital nature of NFTs also increases the likelihood of scams. For example, fake Twitter accounts may advertise exclusive drops, or OpenSea may host counterfeit versions of NFT art.
- Early Stage – NFTs don't have the same track record as other collectibles, making them riskier. At the same time, the new technology could experience growing pains.
In summary, NFTs offer a unique opportunity to invest in early digital collectibles, but it's still a new market. As a result, non-tech-savvy investors may want to steer clear of the market until they work out all these kinks. However, if you're comfortable with cryptocurrencies and digital tokens, you may wish to consider adding NFTs to your portfolio.
How to Value an NFT
The valuation of any collectible item is highly subjective. For instance, someone that doesn't watch baseball may not be willing to pay anything for a rare baseball card, whereas a baseball fan or avid collector might spend thousands of dollars. Moreover, the amount people pay changes over time, as shown by fads such as Beenie Babies.
Despite the subjective nature of valuing collectibles, a few principles can help provide a framework for coming up with a valuation.
Economics 101 teaches us that price depends on supply and demand. Therefore, the price will increase as the supply decreases, assuming demand remains the same. Many collectibles derive their value from supply scarcity. For example, fine wines become more valuable over time because the supply decreases as people drink them.
Of course, there's nothing to stop an artist or platform from launching new NFTs to increase supply. When that happens, investors could see the value of their existing NFTs decline if demand remains the same. As a result, investors should seek out NFT collections with a limited supply and artists or platforms that don't want to cannibalize their market.
The easiest way to quantify scarcity is using a rarity score. In essence, these scores are numerical values that capture each NFT’s relative scarcity based on traits like clothing, facial expression, or accessories. Collectors may consider the rarity of an individual trait or look at an aggregate rarity score that factors in all of the traits to determine scarcity.
Most collectibles don't have much utility, but many NFTs have use cases beyond collection. For example, Axie Infinity is a play-to-earn game with NFT-based characters. When you purchase an Axie, you can rent the player to others to generate a passive income. Investors can value these yield-generating NFTs using conventional techniques (e.g., DCF).
In addition to generating yield, NFTs may provide access to exclusive content or events. For instance, Bored Apes offer access to exclusive in-person events with other owners. And Decentraland ownership includes access to local communities and virtual events. Investors may want to consider the value of this access as part of an NFT's valuation.
Most investors try to value an asset to determine the price they pay, but in some cases, prices can influence valuation. For example, investors might look at the difference between an NFT’s price and a collection's floor price (e.g., the lowest price in a collection) or a collection's average price to determine if they are over- or underpaying.
Other investors might look at price trends and fear/greed levels. For example, an NFT collection with a quickly rising floor price might lead some investors to speculate that the price will continue its ascent. They may even use technical analysis to determine the trend's strength or predict when the price might break out from a previous trend.
The rarest piece of art in the world is worthless if there aren't any buyers. Similarly, the valuation of an NFT depends partly on how many willing buyers exist. The best way to gauge that metric is to look at liquidity – or the transaction volume. So, for instance, you might consider the artist's transaction volume or the secondary market volume within a collection.
The most popular and liquid NFTs leverage the ERC standard, which makes them easy to trade on different platforms without much friction. However, some NFTs trade on proprietary platforms or less popular blockchains. As a result, these NFTs may have less liquidity and, consequently, a lower valuation.
Many collectors base their purchasing decisions on the artist's reputation and ownership history. For instance, a highly-regarded artist with pieces in the homes of wealthy collectors will command a premium over lesser-known artists. These same dynamics apply to NFTs, where many investors look at ownership history – especially among "whales."
Similarly, Decentraland, Axie Infinity, and other NFTs derive a lot of their value from the size and history of their communities. As a result, investors may look at everything from the project's whitepaper to the development team's background to the number of Discord users to assess a project's history, popularity, and staying power.
NFTs have different technical features that may influence their valuation. For example, creators might mint NFTs on a proprietary platform. While these platforms may offer lower costs for creators, the lack of interoperability could negatively impact the price. On the other hand, creators that mint NFTs directly on the blockchain have more options but higher gas fees.
The digital nature of NFTs also makes them susceptible to attack. For instance, Axie Infinity NFT owners lost $620 million after North Korean hackers spear-phished an employee. Therefore, investors should incorporate blockchain security into their decision-making process – particularly for NFTs that trade on proprietary platforms.
In addition, investors should ensure to host the data encoded into an NFT in a reliable location. On-chain metadata is typically the most secure since there's no risk of a shutdown, although decentralized hosting (e.g., IPFS) is also a safe option. After all, if the metadata disappears, the NFT could become worthless.
NFT Valuation Tools
Creators, collectors, and investors looking to value NFTs also have access to a growing range of community tools that leverage these factors and others to estimate value. For example, Moby shows you when the average price of certain NFT collections or the number of sales within them increases. NiftyKits NFT Artist Calculator can even help artists price their collections.
The most popular tools include:
What's in Store for the Future?
The NFT ecosystem continues to evolve at a breakneck pace. While digital art and play-to-earn games have dipped slightly in popularity, NFTs will become instrumental in Web3 and metaverse. They could become necessary forms of identification and enable the transfer of data across platforms, putting power back into the hands of users.
At the same time, NFTs will be critical for tokenizing conventional financial assets. Fractional real estate ownership through NFT tokenization could enable anyone to generate passive income from real estate projects. In turn, that could help democratize a multi-billion dollar market. These trends could open the door to new opportunities for investors.
However, these trends aren't to say that NFT collectibles and play-to-earn games will cease to exist. Instead, they may simply evolve into new formats. For instance, future NFT collectibles might be items that exist in popular metaverse platforms rather than games. Or, they might provide holders with certain community rights or capabilities.
A Brief Note on NFT Taxes
The IRS considers virtual currencies, or cryptocurrencies, property from a tax standpoint. However, the tax agency hasn't provided any NFT-specific guidance, leading to a lot of ambiguity for investors. And since NFTs are non-fungible by definition, they certainly fall under a different category than virtual "currencies" that are fungible.
Most tax experts agree that the IRS will consider NFTs in the hands of their creators as non-capital assets and those in the hands of taxpayers other than their creators as capital assets. If that's true, any capital gain or loss on the sale or exchange of NFTs would be subject to capital gains and losses - although it may be subject to a collectibles tax rate.
You should also remember that an NFT purchased for personal consumption (e.g., a piece of artwork hanging on a wall) that becomes worthless is not deductible under Section 165(c). However, if taxpayers purchase the NFT in a trade or business context, they could take a deduction for the worthless asset under Section 197.
When investing in NFTs and other assets, it's essential to incorporate taxes into the calculus. Doing this is especially true for investors that fall into higher income tax brackets since they tend to pay a higher tax rate.
The Bottom Line
NFTs have become a multi-billion dollar asset class, drawing in investors from all walks of life. While you might dismiss the $69 million sale of Beeple's JPEG image as outrageous, NFTs are revolutionizing everything from traditional financial assets to digital assets in the metaverse. The challenge for investors is finding real value in these assets.
Keeping the six NFT valuation principles above in mind, you can better evaluate NFTs and decide if they deserve a place in your portfolio.
If you trade NFTs or other crypto assets, ZenLedger can help organize transactions, compute capital gains, and generate the tax forms you need each year. The platform can also help you identify opportunities to harvest tax losses and reduce your year-end tax burden.