Metcalfe’s law, originally stemming from telephones and ethernet, says that the value of a network grows with the square power of the number of users. The reasoning comes from counting the connections between those users. If a network has users, the possible pairs, or connections, is .
So for example if a network has ten users, the number of connections is
$10(10-1)/2 = 45$.
With one hundred users, the number of connections is
$100(100-1)/2 = 4950$.
Very loosely, multiplying the user base by ten, one-hundred times the number of connections.
When it comes to analyzing a business and understanding its network effects, the finding is that the business becomes more durable as it grows since each user directly makes the product more valuable. A competitor with half the users would be about a quarter as valuable. This leads to a situation where new customers almost always select the biggest incumbent network and stay there.
In reality, the valuation technique doesn’t hold true and is not consistently accurate. We can’t use it to value internet network businesses. There are a few reasons why this is the case.
- Metcalfe’s law assumes that every user can connect with any other user. This is often not the case, especially with internet network businesses, like Meta, Youtube, Amazon, or Booking. These are two-sided networks connecting creators and viewers, or buyers and sellers. Here the value of the network is likely closer to a pure multiple of Buyers x Sellers.
- The law also assumes that the value of the network continues to grow indefinitely with each added connection. In reality, in most networks, most connections are never used. Is Facebook more valuable to me in Canada because the 1 billionth South American that I’ve never met joins? Some researchers have argued for different vale growth rates because of this.
Connections
Investing Is A Qualitative, Not Quantitative, Game
Link Explanation: More time should be spent analyzing a businesses moat, its durability, than the quantitative valuation. If you own a business and it keeps generating cash for long enough, you’ll get rich, just then just a waiting game. The current note, provides a detailed look at understanding the math behind network effects, which is a form of moat.