Financial side of NFTs and money making questions (Pt. 1).

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  1. Scarcity and preference: An experiment on unavailability and product evaluation

More and more NFT projects are coming out every day. Different blockchains, different styles, different utilities. A question of oversaturation has been addressed by us some months ago and is perhaps a topic that will see the light of professional financial advisors in the future too, or at least when they discover the NFT market and accept it as a prodigal son as the crypto market once was.

Nevertheless, once in a while, every one of us should question their life choices, with the NFT project selection being one of them. Should I buy it? Should I avoid it? It is absolutely normal to feel this way and definitely demands some degree of critical thinking in the first place.

In this short article we would like to address this question and perhaps share some useful information that can help one avoid making mistakes when it comes to NFT buying. However, since we have touched on the matter previously in the article ‘‘Another bubble, or why…’’, shall not repeat ourselves, but rather focus on the financial side of things in depth.

First of all, for those who are always ready to argue that an NFT is just about art itself, we must point out the obvious difference between a professional athlete (looking to make a career, earn fame, glory and money) vs a keen sport enthusiast (doing for the fun of it). Although, some NFTs certainly look more organically in a picture frame in a dining room or an art gallery, the overwhelming majority simply look cool and interesting at the most. Yet, the price of those cool, or even some ‘lame jpegs’ can be somewhat astonishing, especially to the older generations.

For instance, everyone, even the individuals most distant from the whole ‘digital era’ has heard about Crypto Punks as an example of some pictures that cost a substantial amount of money. One might wonder, why so? Do they have some rewards, benefits of ownership and other features that we might consider utilitarian? The answer is no, they do not. However, as more people arrived at the NFT topic, the demand for the OG projects has naturally risen. It might seem odd and illogical to some, but those same people would not mind getting a real Crypto Punk for themselves, right? In the end, it is all about demand and hype. As long as more people want something than the supply for it exists, there would always be a market for rising prices. Even if the item in question is completely useless and does not generate any direct and/or tangible benefits to the owner. Yes, we are illogical beings, let’s face it. Remember spinners? How is it different than a Monet, apart from the craftmanship and numbers? Moreover, given that the original Crypto Punks were often (if not always) given to the owners for free (yes, absolutely free), it makes the current prices seem absolutely crazy. If we imagine for a second, that all of the current owners of the original Crypto Punks realize that their punk does not provide any real benefit, in theory, the price would immediately drop to zero. If you got it for free and it does not provide you anything — it’s essentially worthless. But, since there is a self-fulfilling demand, the prices are high and keep rising; we want it because others want it. This is exactly what a well-known amongst economists Endowment Effect is (the discovery of such behavior is often attributed to Thaler in 1980 and Kahneman and Tversky in 1984).

But we digress, let’s get back to the financial stuff! How shall we value an NFT and what to consider?

Dive into discounted cash flows

Okay, for the purpose of this exercise we shall say that we are completely pragmatic and cynical beings, who despise art of any form and only value true monetary rewards. So, let’s imagine an NFT project of ‘Cool Kids Club’, on a blockchain of Kappa blockchain. In order to assess whether we should or should not get into CKC we are required to know a few things: 1) price of acquiring this NFT, 2) value of the rewards that we shall receive, 3) our risk-free interest rate and 4) our time frame. Let’s break each of these down.

The price of acquiring merely refers to the price at which we can enter the project, that is the price of buying this NFT. There are two possibilities present, namely minting a new one straight from the project’s drop or buying one from the secondary market. Whichever path we take or are able to choose will therefore determine the price of acquiring this NFT, pretty self-explanatory. Obviously, if we can get an NFT from the drop at, let’s say, 10 Kappa, while the secondary market’s floor is 9 Kappa — we should opt for the latter since it’s cheaper.

Value of the rewards refers to the sum of all monetary rewards we are expecting to receive from owning this CKC NFT. And by the expectation we mean certain outcomes and not chances to receive some rare and valuable airdrop. (Of course, we can take those into account too by using expected outcome function. For instance, if we have a 10% chance of receiving $10000 worth of something, then the expected payout can be calculated as 10% * $10000 = $1000). So, if we are expected to receive $1000 from our CKC and nothing else, then the expected value is $1000. At this point we do not consider the capital gain upon the sale of the NFT at a later stage (or loss).

A risk-free interest rate confuses many people, even those starting to study finance. The risk-free interest rate is exactly what it says on the label — the highest percentage you can receive for the same investment with no risk. Usually, this is the bank’s deposit interest rate that is used, as it is considered risk-free (with no risk of bank’s default, essentially). However, it does not have to be a bank and can be any investment opportunity that is considered by you as riskless, i.e. if you loan some money to your friend and he is guaranteed to pay back with 10% interest, then we can say that your risk-free interest rate is 10%. Moreover, the risk-free interest rate is subject to one’s evaluation too, as two individuals can perceive the same project to have two different risk levels. (Since large and reputable banks of stable countries are considered by the majority to be safe, the interest rate of their deposits is often used for this calculation. Alternatively, government bonds of the highest security level can be used).

A time frame of the expected return also plays a crucial role in the calculations. The idea of timeframe is directly related to the aforementioned interest rate and makes sense logically too. Hundred dollars today is not the same as hundred dollars in a year. And this is not only attributable to the inflation itself, but also to the interest rate and human valuation of what economists refer to as ‘immediate gratification vs delayed gratification’. The concept of it is quite basic, yet causes quite a lot of various peculiarities when it comes to human behavior.

Mental experiment: if you can choose to receive $100 today or $200 in two weeks — what would you choose? Now, if that was changed to $100 in a year or $200 in a year and two weeks — how does your choice change? According to various studies, most of the respondents opt for immediate gratification in the first scenario, yet can wait for another couple of weeks for an increased reward. However, in both cases, the timeframe separating the rewards is kept the same. Human behavior is weird, huh?

If we imagine choosing between two nearly identical projects, where one is expected to yield us $100 in a month and the other to yield $100 in two months, it is only logical to choose the former. What about $100 in a month or $1000 in a year? That’s why the timeframe is important.

Now, having identified all of the participants of the basic model, let’s actually bring the model together. It has the form of:

Source: investopedia.com

Where DCF = Discounted Cash Flow, CF = Cash Flow in the respective period, r = risk-free interest rate, and the number index / power = time period (on an annual basis if ‘r’ is also on annual basis).

So, if the payout is expected only in period 1, the formula boils down to CDF = CF / (1 + r). For example, if our riskless interest rate is 10% and we expect a payout of $100 in exactly one year, then the DCF = $100 / 1.1 = $90.91 in today’s money. For two year like this, DCF = ($100 / 1.1) + ($100 / 1.21) = $173.55, etc. So what, I hear you ask. Well, if we have to pay anything more than the corresponding DCF, or the expected payback of the NFT, then you are effectively losing money. Again, in this case, we omit the value of reselling this NFT at this stage, as well as the sentimental value of liking the art itself. If, for instance, we can resell this NFT for $50 after two years, then in total we would have gotten: $173.55 (from DCF) + $50 (from reselling) = $223.55, which is $23.55 greater than the $200 of acquiring the NFT. In this case we can say that it is a profitable investment and we should definitely get into the project.

Of course, in reality, we have limited funds and will have to gauge this profit against other projects which can yield us more profit or the same, but in a shorter time.

So, all-in-all, when considering whether you should buy a ‘Cool Kids Club’ NFT you should do a quick back-of-the-envelope calculation of the expected payout and gauge it against the price you’ll have to pay to acquire it. However, as we have pointed out previously, the definition of risk-free interest rate varies in reality for everyone, based on their judgment, as well as assessment of the expected future cash flows (are you sure you can resell this particular NFT x2 in a year?), and many other factors. Nevertheless, this basic model, especially once it becomes a subconscious habit, can make your choices easier and save some money at the very least, if not making some.

At this point, once the model makes sense and seemingly explains many of the choices we might have made in the past, there appears a deeper feeling that something is not right. And it truly isn’t. The issues with this model just like any other financial and economic model, is that it is a good approximation and sometimes can be far from reality. How do we calculate the value of, let’s say, access to exclusive information about our favorite hobby? Or how do we evaluate a less certain outcome of a potential project’s collaboration in a fast changing environment? Also, imagine reselling an NFT after some period of time. What is the market price for it? Are the buyers as pragmatically logical as we are and calculate the intrinsic value or they place a larger weight on the sentimental artistic part of this NFT? Is our risk-free interest rate the same as the other person in the market has? Do we have the same level of patience and, thus, timeframe? All these and many other question complicate the model and thus cloud our final conclusion. However, please do not underestimate the power of this basic DCF model either! It is certainly far from being prophetic, yet provides ample fundamental data and therefore serves as a good starting point.

Still with us? Okay, great! Let’s make it a little more visual by looking at some examples in the real market featuring GPool, Theta Teeth and Mystic Gurus NFTs.

  1. GPool project and Tbill multipliers
    (We must admit our personal fandom for this project and the ingenious team behind it, yet we will try to assess the NFTs objectively.)
    Although the GPool project itself can be described mostly by some combination of the words ‘blockchain, crypto currency staking and liquidity pool’ we shall focus on their multiplier NFTs within the topic of our article. GPool Multiplier NFTs introduced a set of NFTs that provide the holders, as the name suggests, an x2 return to their staked holdings. So, if we consider an investment of $100,000, the staking process itself would yield us exactly $50,000 or 50% in a year. The same investment, on the other hand, with an x2 Multiplier (for 100k Tbill) NFT would accrue $75,000 in a year. Given this, we can extrapolate that the multiplier itself generates us $25,000. If we, for simplicity’s sake assume no compounding and that the $25,000 is given to us at the end of the year, we can calculate the DCF for 5-year span at 10% interest rate as follows:
    DCF = $25,000 / 1.1 + $25,000 / 1.12 + $25,000 / 1.13 + $25,000 / 1.14 + $25,000 / 1.15 = $94,770. So, essentially, In 5 years time, the NFT would yield us almost the same amount as the principal (stacked investment) itself. This is not to account for the staking return, but simply the NFT’s added value and the corresponding DCF. Not bad, right? Also, we need to point out that we took a very simple approach of not compounding the interest at all, which would unlikely be the case with such lucrative returns for most of us. So what, I hear you whisper? Is the NFT worth $100k then? Well, if we calculate the value for a 10 year period, the value would be $153614. And if we assume this working in perpetuity? The net present value would be calculated as $25,000 / 0.1 = $250,000. Whoa! The NFT is worth $250,000 (2,083 million Tfuel) based on mathematics. Why do we see them on the market for about $4600 (39,000 Tfuel) then? Be completely overwhelmed by the fact that these NFTs were mintable for around 7,000 Tfuel originally.
    Well, that is the funny part about our irrationality as a biological species, as well as the lack of financial understanding for some of the participants. We shall not focus on these at the moment, but will certainly spare some attention next time. Also, please note that we have oversimplified our calculations as well as the numbers are subject to the market exchange rates and price fluctuations. If you are interested, you can fiddle with the numbers on the official website and community-based website.
  2. ThetaTeeth, ‘hunters’ tokens’ and direct financial rewards
    Theta Teeth project provides a little more straightforward system, as all of the immediate and tangible returns are set in Tfuel — the coin of the initial sale. The entire collection of 3232 NFTs is split into 5 Tiers, with each consecutive tier increasing in price by 50 Tfuel. Not only does this provide the ‘early birds bonus’ to the early adopters (since the floor price is likely to be at least the price of the Tier 5 minting), but also, the holders of earlier Tiers split the 5% of the sale of the next Tiers. So, for instance, if you own a Tier 1 Theta Teeth NFT, you would receive 12.5, 9, 8.2 and 7.5 Tfuel from the respective Tier sales, totaling around 37 Tfuel from the ‘cashback’ alone. Additionally, given that the project rewards its holders with 5% from the income of the next projects (Theta Teeth act as perpetual tokens essentially), the holders would profit from the MATRËSHKA dollhouse sellout too. Let’s say you hold a single ThetaTooth and MATRËSHKA makes a total profit of 10 mil. Tfuel, then you would be eligible for 10,000,000 * 5% / 3232 = 154 Tfuel. Using the DCF model at 10% risk-free interest rate and the timeframe of 1 year, this would translate into 140 Tfuel of today’s worth. So, in total, acquiring a Tier 1 Theta Tooth for the minting price of 200 would yield you 37 + 140 = 177 Tfuel within a year. And that is only considering direct financial reward in 1 year time period, while completely disregarding all of the airdrops, access to valuable Bit Quest-related info, staking, merchandize, cashback from additional sales and future projects, amongst other proprietary and collaboration features. Not bad, right? That is why we recommend to study the website and the whitepaper (and MATRËSHKA too!)
  3. Mystic Gurus meditating and NFT staking
    Mystic Gurus NFTs provide the owners with a staking opportunity, called ‘meditating of the guru’ and yields AURA token. At the moment of writing, according to some friendly and sociable visitors of the Shrine, the congregation accounted for about 75%, or 416 Gurus. In other words, 416 MG NFTS have been staked with 600,000 AURA tokens distributed to the wallets already, that is 1442 AURA tokens per your staked MG NFT. Of course, such a high reward is not infinite and is currently an x10 of what the following reward would be, yet this already provides the owners with a great return. However, one might wonder how to calculate the exact DCF at this point, to which we would recommend to wait and see. Once the exchange rate for the AURA token to USD or Tfuel is known, we can readily apply the DCF model and get our answer. Moreover, just like with any other project, we shall consider the capital gain profit (if we choose to sell) and somehow evaluate the non-monetary benefits from holding a Mystic Guru. In order to better understand the importance of staking your MG, like the leveling system and AURA rewards, we recommend you to be mindful of the website and the white paper.

Hopefully, these few examples have helped the readers just like textbooks have some examples solved and commented step-by-step. Of course, just like we have mentioned along this article, the DCF model offers a good approximation to the expected financial rewards that can then be gauged against the price of required investment as well as other investment opportunities of other projects and assets. However, as we have witnessed, some intangible benefits can be hard to assess directly and most importantly can have two very distinct values for different individuals. That partly explains why every NFT project has its own group of followers and critics, who can switch roles when it comes to other NFT collections.

All-in-all, the important outcome of this article is that while NFTs can sometimes seem promising due to the surrounding excitement, it is still a good idea to apply some simple arithmetics and deem an NFT as a financial asset. Bear in mind that we are talking about a cold-blooded and calculated approach, completely withdrawn from personal fixations over the art or the team behind it (Although, economists can attempt quantifying even that, as there would be a magic number for which one would forgo a piece of art).

Another important derivation one might come to is that human nature is indeed very illogical at times and prone to many biases. In fact, those behavioral biases and heuristics gave birth to a completely new branch of studies — behavioral economics and finance. Knowing or at least being aware of such tricks our minds play on us is crucial to making more rationalized decisions when it comes to finance. And let’s face it, very few of us are present in the NFT space due to the love for art.

N.B. Part 2 will be on the way soon and will delve into the topic of behavioral finance a little. Very interesting, somewhat surprising and absolutely necessary to know!

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