Following one of my earlier post on the back art of valuation (valuation 101), interesting post on Metcalfe's Law, Reed's Law Revisited: Questioning new Valuation Models.
- During Bubble1.0 analysts said "CMGI can grow at 150% as far as the eye can see so it makes sense to pay 1000 times earnings for them". Now the thinking is that if you can grow users 50% per annum, then the value of your user base grows in value even faster--by maybe 200% each year. Such is EBay's logic behind the $3 Billion price tag for the profitless Skype. These lofty valuations are based on so-called network effects.
- Reed's law is Metcalfe's law on steroids. Metcalfe's Law states that the value of a network is roughly equivalent to the square of its nodes. IM clients, and p2p file-sharing apps might be examples of this. Belief in this phenomenon plus new technology enabling collaboration has resulted in boatloads of money being poured into the "social software" space. Again, lots of folks are looking for the next Skype. By the way, Reed's Law, which I don't quite understand is even more bold, because instead of a network being valued as n^2, where n is the number of users (nodes), n becomes the exponent, valuing the network as 2^n..
=> Where is the recognition that many kinds of networks degrade with size. Take del.icio.us, which I love. I subscribe to the finance-tag feed. So everyday, I see 50 or so headlines to articles that discuss finance. If, one day, it got bought out by Google, that number turned out to be 500 I'd stop reading the feed. Perhaps, I'd switch over to del.irio.us.
Even if a network is able avoid degradation, it's inevitable that growth will taper when new nodes start to become irrelevant or redundant. Such was the conclusion of two economists who discovered that Metcalfe's law overshoots the mark big-time:
Metcalfe's Law came from Bob Metcalfe, a founder of networking equipment supplier 3Com and coinventor of the now-ubiquitous Ethernet networking standard. According to the law, a network with 20 telephones--or alternatively, fax machines, instant-messaging teenagers or Internet-phone callers--is four times more valuable than a network with 10. A network with 30 nodes is nine times more valuable than one with 10.
Not so, Odlyzko and Tilly argue. "The fundamental fallacy underlying Metcalfe's (Law) is in the assumption that all connections or all groups are equally valuable," the researchers report.
If Metcalfe's Law were true, there would have been tremendous economic incentives to accelerate network mergers that in practice take place slowly. "Metcalfe's Law provides irresistible incentives for all networks relying on the same technology to merge or at least interconnect."
The researchers propose a less dramatic rule of thumb: the value of a network with n members is not n squared, but rather n times the logarithm of n. That means, for example, that the total value of two networks with 1,048,576 members each is only 5 percent more valuable together compared to separate. Metcalfe's Law predicts a 100 percent increase in value by merging the networks.