A Penny for your Dunk: finding the value of NFTs

Part 1: A Penny for your Dunk

Non-Fungible Tokens, or NFTs for short, have taken the world by storm. On NBA Top Shot, a digital collectibles platform, individual Zion Williamson and Lebron James “Moments” have sold for well over $100,000. Within the digital arts space, the artist Beeple sold a collection of 5000 paintings for a whopping $69 million. More recently, Jack Dorsey’s first tweet was purchased for $2.9 million.

The incredible run-up in NFT prices has turned many heads. Yet few people can agree whether NFTs represent the next frontier of ownership or a massive speculative bubble. So here, today, we will attempt to answer the literal million dollar question: just how much is a digital LeBron dunk really worth?

As always, we will use history to guide our examination of the future.

We should first note that the underlying purchase motivations behind NFTs are not new. From exotic sea shells to beautiful gemstones to rare art, we humans have always enjoyed collecting stuff. NFTs simply digitize those collection experiences.

But why do we collect at all? Well, the simplest answer is that it brings us joy. We like sneakers, or coins, or wine. Yet few sneakerheads hoard boxes of plain Jordans and few coin collectors own rolls of generic-looking US quarters, because those things are not scarce. A more accurate description of scarcity is a fixed supply: no matter how many people want the 1869 Chateau Lafite, we cannot produce more of it. Jordans and plain ol’ quarters can be produced ad infinium.

The intersection of constant/growing demand against a fixed supply is what gives collectibles value. If we think future generations will continue to enjoy Lichtenstein’s Pop Art, we can reasonably assume that his art will hold in value. Which leads to the second reason why we collect: to preserve wealth.

Collectibles have often been compared to gold as stores of value. The key difference between the two is that gold is fungible: one ounce of gold is worth one ounce of gold. By contrast, every Monet water lily is different, to say nothing of the difference between Monet and Manet. In other words, collectibles are non-fungible, and their values need to be ascertained individually.

So let’s talk about valuations. Luckily for this blog, there is no better place to understand the economics of collectibles than—you guessed it—games. Specifically, baseball cards, Pokémon cards, Magic cards, and so on. The economics of these trading cards give us the best heuristic on how to value NFTs. So let’s get started!

Part 2: A step back in time: from Mickey Mantle to the Black Lotus

When we hear headlines of $350k Charizards and $5.2 million dollar Mickey Mantle Rookie cards, we first have to remember that collectible cards are not scarce. Many of us likely have Pokémon cards left over from our childhoods, and many new packs are sold everyday. Most of these cards are worth little.

The key to collectible cards, as their creators understood years ago, is to create artificial scarcity within a world of abundance. In 1993, the company Wizards of the Coast released the trading card game Magic: the Gathering. Set in a fantasy world, Magic inspired many popular derivations that include Pokémon and Hearthstone.

Magic cards were sold in packs. The rarity of cards within these packs followed a pseudo-logarithmic curve: certain powerful cards were exponentially harder to find than common cards. This created the first layer of scarcity.

The second layer of scarcity came through Magic’s release schedule. Magic cards were released in sets that lasted for one to two years. Certain “limited edition” cards could only be found within sets issued during a specific time window. Once the set finished, no more of the “limited edition” cards would be issued.

The final layer of artificial scarcity came through “card grading”. Grading measured card wear and tear (a creased corner, for example). Ratings ranged from 1 to 10 and are officiated by PSA, a third-party company. Ostensibly, card grading helps collectors identify imperfections. In reality, an 8-rated card looks almost identical to a 10-rated card, even as the two fetch vastly different prices. The bigger role that grading provides is to create more “tiers” of scarcity. In a non-fungible world, collectors lean on every marker to separate the best from the rest.

As Magic: the Gathering became more popular, cards from the game’s infancy became more valuable as collectibles. The Black Lotus is the most famous; it was printed exclusively during the game’s Alpha and Beta release in 1993 and 1994, and was so powerful that Magic later banned it from competitive play.

In 2020, a PSA 10, Alpha Black Lotus sold for $250k. It was the apex predator of the Magic world: one of the rarest, oldest, most pristine cards in a game of increasing popularity—in other words, a perfectly scarce collectible.

The last crucial ingredient to collectible cards is brand longevity. Baseball cards get around this through licensing; presumably people will always care about the MLB. Pokémon and Magic have stood the test of time over decades. Few other collectible card brands have lasted through the ages. Many that showed early promise, like Dragon Ball Z collectible cards, have faded away from collectors’ conscience, and even their rarest cards are worth very little today.

Part 3: Putting a price on LeBron and Zion

In building NBA Top Shot, Dapper Labs has done their homework on the trading card economy. To start, their partnership with the NBA ensures brand longevity. This contrasts to other NFT start-ups that build on proprietary brands, which are much less likely to endure the test of time.

Like collectible cards, Top Shot “Moments” are sold in packs. Moments range from common to legendary to ultimate, signaling the scarcity of each Moment. Cards within each set have a limited and fixed supply. For example, some Legendary Moments have 49 copies in circulation. Common Moments have many thousands of copies. It’s without saying that the rarer the Moment, the better.

Unlike physical cards, Top Shots Moments do not have wear and tear, so card grading does not apply. This means Top Shot needs other differentiators to mark scarcity. Some differentiators are obvious: a Legendary Steph Curry is worth more than a Legendary Svi Mykhailiuk, and a Legendary Steph Curry shooting a 3-pointer is worth more than a Legendary Steph Curry assist.

Other differentiators are more nuanced. Every Moment is given a serial number as part of its collection. For example, there are 49 copies of the Legendary Cosmic Reggie Bullocks, and each copy is marked with a serial number between 1 to 49. The Moment with the serial number that matches the player’s jersey number (in Bullocks’ case #25) is marked with a slightly different color, hinting that this card is the most desirable.

Let’s find the rarest Moment in Top Shot. It will likely be from series 1 (first series are almost always the rarest), a Legendary card, popular player, with matching Jersey number. Putting all this together, we have a few candidates. Topping that list is the Series 1, Cosmic Legendary Zion Williamson, card serial #1, which just happens to be Zion’s jersey number. This will likely be one of the rarest Top Shot moments of all time.

So how much is this Moment worth? Well, the closest comparison would be either basketball cards or baseball cards. Baseball cards have the longest history of all sports trading cards, and hence the highest price value. For that reason alone, we’ll use baseball cards as a benchmark. One of the most expensive baseball cards is the 1952 Mickey Mantle Rookie card, which most recently sold for $5.2 million. This represents a near-term price ceiling.

But to assume Zion costs $5.2 million today would be wrong. Afterall, baseball card collecting has been around for literally centuries, whereas Top Shot is still very nascent. It may be that, in the decades to come, Top Shot becomes the NBA equivalent of baseball cards, but many factors could also derail that. Maybe NFTs won’t become viable long term. Maybe Top Shot will be supplanted by another NBA-licensed NFT. Maybe adoption never reaches the mainstream. Maybe the NBA revokes their license in favor of a first-party product they can control. To account for these uncertainties, we have to introduce a probability factor to pricing, and the formula would look something like this:

Price (Rarest Baseball Card) * Prob (Top Shot mass adoption) = Price (Rarest Top Shot Moment)

On January 15, the collector ‘jerlevine’ bought the Zion card for $100,000. This price implied a long term adoption probability of around 4% ($100k / $5.2m). I’m inclined to believe that was a rational price to pay for the time.

What’s more, as Top Shot’s fan base grew exponentially over the past months, we should also assume the implied probability of long term adoption also went up. According to our formula, this pushes up prices. Indeed, just a month later, an anonymous buyer offered ‘jerlevine’ $1m for the Zion card, which he turned down. $1m would imply a ~20% probability of long term adoption.

While I don’t want to speculate on the “right” pricing and implied probability for this moment, we can see that the math breaks down at some point if the prices continue to go up.

Part 4: NFT business model differences vs traditional collectibles

Our analogy so far compares Top Shot to traditional collectible cards, but there are key economic differences between the two that we need to acknowledge.

When we buy a Mickey Mantle or Charizard, we have complete ownership of our card. What we do with that card is completely irrelevant to the publishers of the card. If we choose to sell it on eBay, or Christie’s, or rip it up, we can.

By contrast, Top Shot and certain other NFT collectibles exist within semi-closed ecosystems. Top Shot “Moments'' are held within Top Shot accounts; trading is conducted exclusively within the platform; even the underlying cryptocurrency that powers Top Shot (Flow) is created by Top Shot’s parent company.

This setup is likely driven by business incentives. By controlling player-to-player trading, Top Shot can take a cut of each marketplace transaction as commission. It’s therefore in Top Shot’s interest to prevent the transfer of “Moments” to private wallets and decentralized exchanges. At the time of writing, transfers to private wallets have not been enabled.

Yet this setup also creates risk for collectors. Mickey Mantle card owners would not be much affected if Topps (the card creator company) goes bankrupt tomorrow. But Dapper’s demise would pose an existential risk to the value of “Moments”. Collectors need to account for platform dependency risk within their valuation models.

Not all NFTs are built this way. The soccer collectible Sorare and the collectible card game Gods Unchained allow their NFTs to be transferred and sold via third party marketplaces such as opensea. If NFT follows the broader cryptocurrency trends, these decentralized models will likely be favored in the long run.

Part 5: Perspectives on the broader NFT ecosystem

Top Shot is far from the only talk in town. From Jack Dorsey’s Tweets to digital sneakers, interest in NFTs have exploded over the past months. Yet valuing the wider NFT universe is a lot more difficult than valuing Top Shot.

As we’ve seen so far, the value of any non-fungible good comes from three factors: scarcity (either natural or manufactured), “tiering” (the ability to force-rank among non-fungible items), and anticipation of future demand.

Take vintage wine as an example. It is scarce because only so much vintage wine exists in the world (scarcity). It can be force-ranked by vineyard, by wine type, and by vintage (tiering). We can be reasonably assured that wine culture will continue into the distant future (future demand).

In contrast, NFTs simply enable the ownership of digital assets. They do not solve the core questions of scarcity, tiering, and demand predictability. Take digital art: a quick peruse through DiviantArt and ArtStation tells us of the vast potential supply in digital art available for conversion into NFTs. Further, since digital artists can always produce more work, supply of digital art is extremely elastic.

What about long term demand? Here it also gets tricky. From sneakerheads to wine aficionados to Pokemon lovers, core groups of collectors form the bedrock of any existing collectible ecosystems. Strong interest groups do not yet exist for the vast majority of NFT categories today. Will there be groups of connoisseurs for rare tweets over time? Possibly. But such groups do not exist today. Any price paid for tweets today assumes a certain probability that these groups will develop the future. Like the case with Top Shot, at some price point, the implied probability will overshoot actual probabilities.

Finally, what about tiering? In the art world, art historians and curators provide “tiers” by contextualizing artists within broader art movements, and individual pieces within artists’ lives. This process happens slowly and often in hindsight. For better or worse, they guide collectors towards price valuations among the infinite supply of physical art. Many artists, like Van Gough, don’t reach critical acclaim until after their death (which conveniently also caps supply).

In contrast, the fast-moving world of NFT digital art makes it hard for this organic process to unfold. In its place we find more reductive forms of valuation. One form is crowding: simply paying for things that others are paying for. Before Beeple sold his 5000 days, he sold an animated work called Cross Roads for $70k. It was re-sold for $6m just months later. As more collectors started to crowd his work, the valuation on 5000 Days became more interesting—it represented 10+ years of work and documented his artistic beginnings. Given the sheer timeframe covered by 5000 Days, it will be unlikely for Beeple to release another piece of such monumental undertaking.

But crowding also leads to speculation: people pile into things simply because others are piling in, without deeper reflections of long term supply and demand dynamics, until a sort of mania takes hold. This speculative fever crescendos until no more buyers can be found, at which point the speculative bubble bursts.

We’re likely in the middle of a bubble right now, though when and how it peaks is anyone’s guess. We should note that short-term bubbles and long-term opportunities are not mutually exclusive. Decentralized digital ownership will likely play an important role in future digital economies. Some NFTs will become stores of value over time. But such use cases will take time to develop, and will need to be grounded in the principles of scarcity, tierability, and demand predictability. Until more of these use cases catch up to technological advancements, we’ll likely see more speculative volatility.

Companies looking to build in the NFT space would also be well-served to take note from physical collectible industries. The economic principles that ground the physical industry will remain true for the digital economy. “This time is different” may be less so than we are led to believe.

PS. This article can be for sale as an NFT…

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