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January 10, 2020

How do we value blockchain?

At Bitcoin Market Journal, we’re obsessed with finding “key metrics” to value digital assets like bitcoin and altcoins – in the same way that investors have metrics like P/E ratios to value stocks. In this topsy-turvy new world of digital assets, we’re trying to bring order to the chaos.

We started from a simple premise: the health of any economic system would be based—at least in part—on how many people were using it, and how much they were using it.

Based on these principles, we came up with three metrics that we’ll be sharing over the next three weeks. Today, our analyst Kevin Kelly will explain the first of these metrics, the Network Value to Metcalfe Ratio.

Created by Robert Metcalfe and later expanded upon by George Gilder, Metcalfe’s Law states that the effect of a telecommunications network is proportional to the square of the number of connected users of the system (n^2).

The law was initially applied to fax machines at Xerox, and later linked to platforms such as Facebook and Ebay due to their reliance on networks and the internet.

A study conducted by Xing-Zhou Zhang in 2015 found that Facebook’s revenue was almost exactly proportional to its number of monthly active users squared, indicating that an increase in users will inherently lead to an increase in utility and value. The same can be said of bitcoin, as it operates on the same network premises as Facebook, creating a more valuable platform as more nodes (users) join.

To justify using Metcalfe’s Law, it’s critical to establish the why more nodes mean a more valuable network:

As a payment system, bitcoin’s network is one of the largest, resulting in a much higher price than other coins -- since merchants and patrons will prefer a payment system with more activity.
An increase in users also leads to more stability, as coins with larger market caps tend to hold their value in the long term, easing worries of price fluctuations.
Lastly, since it has the most nodes, bitcoin offers more security, due to its total accumulated hashes, which will only increase as its user base grows.

In the world of blockchain, the Metcalfe ratio is (n^2), or the number of active addresses, squared. For example, here’s the Metcalfe ratio for Bitcoin, Ethereum, and Litecoin over the last year:

From this, we can calculate the Network Value to Metcalfe Ratio, or NVM Ratio, a valuable metric for determining whether a digital asset may be undervalued or overvalued.

NVM Ratio: How it Works

Here what goes into the model above:

Price: current market price of digital asset
Market Cap: the value of the total market (number of coins in circulation x price)
Transactions last 24hrs: total number of transactions in the past 24 hours
Average Transaction Value: average dollar value of a single transaction
Transaction Value Last 24 hrs: Average Transaction Value x Transactions in last 24 hours
Active Addresses: total number of active addresses (think of this like wallets)
Metcalfe Ratio (n^2): the total number of active addresses, squared

Equity analysts use a variety of metrics when valuing stocks. One of the most crucial ratios is the price-to-book value, which is calculated by dividing the market cap by total shareholder equity (the balance of total assets and total liabilities). Blockchain assets do not have clear cash flows, assets, and liabilities – so we must substitute certain variables in order to find equitable ratios.

Assuming the value of a network is proportional to the number of active users squared, we can replace “book value” with Metcalfe’s Law, or the total number of Active Addresses squared. (Note that we must use active addresses since an inactive one provides no value to the network.)

The result is a ratio that emulates a common company’s Price-to-Book ratio. Simply stated, a higher P/B ratio indicates that the market is paying a premium price for a stock, as its share price is higher than the “book price,” or the value of all the company’s assets if liquidated on the spot.

Companies such as Apple and Amazon often have high P/B ratios due to the market’s forward-thinking mindset: investors assume that the company’s future value is worth even more than its current assets. In contrast, a low P/B ratio could indicate a stock that is undervalued in the market, revealing a potential buying opportunity.

The same principles apply to digital assets when using the Network Value-to-Metcalfe ratio. In our model above, Ethereum has a NVM ratio of .19 (potentially undervalued), while Litecoin has a ratio of 1.88 (potentially overvalued).

Does this pass the common-sense test? As our team discussed these findings, we felt that Ethereum has a strong developer network, numerous proven use cases, and excellent market penetration. We felt that Litecoin has a devoted following, but a smaller developer community and fewer long-term prospects.

Our common sense told us that Ethereum probably was undervalued (a buying opportunity), and Litecoin probably was overvalued (a selling opportunity). To us, the NVM Ratio holds water.

While no single metric should be taken by itself, the NVM Ratio is one valuable tool for your toolkit – in conjunction with our Blockchain Investor Scorecard, and the other metrics we’ll be unveiling over the next two weeks. Stay tuned.

Kevin Kelly

Analyst, Bitcoin Market Journal

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