Absolutely Crypto: Can You Use Metcalfe’s Law to Get Absolute Value for Cryptocurrencies?
Lesson H: What It Says on the Tin
In the everyday world of consumption, we tend not to question whether the price that we are paying for consumables is a fair reflection of its actual value. We may consider price comparisons — either in terms of businesses matching prices or with regard to the history of a rise in price (inflation!) — but the matter of a consumable’s actual value is another question. You may pay $10 for a bottle of water only because it’s really hot outside and the next convenience store is 100 miles away. But is the $10 its actual value?
Price is not the same thing as value, which has a broader meaning. There is an interesting historical and philosophical debate about their differences which has never been settled. (Students of philosophy will know this dilemma in terms of the tension between what Adam Smith and Karl Marx understood as “exchange value” versus “use value”.)
But let’s try to stick to the familiar surface of things. So, in lieu of immersing ourselves in this debate, let it suffice to say that historically failure to find some sufficient resolution has gone in favor of price. (For more on this, see Philip Mirowski.)
What I mean by this is that economists and finance experts are mostly interested in how much someone is willing to pay for something — that is, its price. And this means, the price someone pays does not necessarily have to take into account that thing’s value. A classic example: someone paying for a worthless commodity because he’s been duped.
Price is relative to a lot of factors, such as supply, demand, preferences, amount and accuracy of information, and specific contextual determinants (see, for example, the history of arbitrage). In sum, the tasks of the economic and financial analyst reside in the prediction and explanation of price movement — the former, in order to understand how it affects economic stability and employment; the latter, in terms of trading.
However, the notion of value rears its head when experts try to understand what the absolute value of an asset is worth. To recap from a previous article, absolute value (AV) is the worth of an asset in itself, without comparison to similar assets. Another way of thinking of AV is in terms of an asset’s intrinsic value.
While AV is nonetheless measured in terms of price (more specifically, absolute price-to-earnings ratio and discounted cash flow), it is nonetheless an attempt to get at a more “honest” appraisal. Hence, AV uses pricing to arrive at the conclusion of whether something is under- or over-valued.
With cryptocurrencies, trying to ascertain something like AV is complicated due to:
- the short history of the market and its projects,
- the dissimilarities between crypto projects and stocks in terms of cash flow, and
- the way crypto projects tend to be network-centric in order to sustain and drive value creation.
However, Metcalfe’s Law, which we have covered in a previous article, can help to get a better idea of what the AV of a cryptocurrency might be.
But first let’s see why more traditional financial approaches don’t really work with cryptocurrencies.
Why Cash Flow Analysis Doesn’t Work
We’re going to consider cash flow analysis in terms of what is often referred to as discounted cash flow (DCF), which is used by experts to determine the AV of an asset.
To recap:
“[DCF] compares the present value of your money to some future state. What’s important to note is that DCF considers the present value of your money as it can be invested and not just the value of your money by itself.” (ibid.)
So, one example might be having $100 which you can invest in a savings account to earn a whopping 10% annual interest. In one year, you’d earn $10. That is a positive discounted cash flow as it relates to utilizing a savings account (the bit about depositing your money in a savings account is important, and I’ll come back to this in the next section). A negative DCF would entail having the $100 but not being able to deposit it in the savings account for some reason or another. So you’d lose out on the 10% annual interest.
Can DCF be applied to cryptocurrencies?
Sebastian Purcell covers how DCG doesn’t really work in his Lesson #5: Bitcoin’s Intrinsic Value:
“Most people think Bitcoin is an asset, and I call it an ‘asset’ by analogy. But it’s not. An asset is something that produces cash flows.
To explain, my university is in a ‘college town,’ meaning that it’s the largest business there. Obviously, there are a lot of college students and they buy a lot of alcohol.
They also get the munchies late at night, when everything else is closed–except for one pizza place. It’s a narrow shop that has almost no seats and sells pizza by the slice. They also do deliveries and they make tons of money.
How much is this Late-Night-Pizza-Joint worth?
Well, theoretically, if you had infinite knowledge, you could just sum up all the company’s earnings–their cash flows (to speak loosely)–and then discount those back to present dollar amounts.
You have to discount the $10,000,000 it makes in 2050 to today’s dollars because of inflation (at least).
So, Late-Night-Pizza-Join is worth the cash flow of 2021 + 2022 + 2023 … for as long as the business is in operation, and then you discount that back to today’s value.
Doing that for a real business is hard because no human has infinite wisdom. But there are standard ways to approximate how to do this — and this is what finance specialists do.
Now, does Bitcoin produce cash flows? Not really. You could stake Bitcoin, and then you would have a Bitcoin staking business, and that would produce cash flows, but Bitcoin itself doesn’t do that.
So, Bitcoin isn’t an asset. You can’t find its intrinsic value that way. So, what do you do?
Well, you have to use a different value model. There are quite a few proposals out there on the internet, and for nerds like me, this is a fun, ongoing debate.”
Bitcoin itself is merely a medium of exchange and a store of value. In its role as a currency, it is not a business that produces a flow of cash. Bitcoin is merely exchanged for other currencies. Similarly, the US dollar does not produce a cash flow. It is the medium by which the flow is measured.
As Purcell notes with respect to staking Bitcoin, a case can be made for applying DCF to cryptocurrency platforms that have their own token namesake and provide a service — such as, a lending protocol or NFT marketplace. So applying DCF to crypto becomes quite tricky since a distinction needs to be made between:
- The platform as a business or company (even though it might be a DAO); and
- The cryptocurrency fueling its operations.
To go back to the US dollar:
Imagine a company sets up shop online and sells McGuffins of every shape and size. The business is called “US Dollar” and it trades in US dollars. If you measure the cash flow of US Dollar (the business), you won’t be getting the cash flow of the US dollar (the currency). You’ll be getting the cash flow of US Dollar (the business) in US dollars (the currency).
Why P/E Ratio Doesn’t Work
To recap (ibid.), price-to-earnings ratio is calculated by dividing the stock price per share by the earnings per share.
It’s essentially the same reason why you can’t use P/E ratio as a measure as it is for DCF. Cryptocurrencies are not assets that produce earnings like shares do. You can exchange cryptocurrencies to make a profit, but that is not an earnings flow that is generated from the coin itself. It’s merely a comparative (spot) exchange advantage.
However, similar to the case of the business “US Dollar”, you can apply P/E ratio calculations to businesses or projects that are involved with cryptocurrencies in some way, shape or form. This has been done for DeFi lenders and yield farming sites where interest rates on liquidity sums provided for borrowing act like assets.
But again, remember you’re not getting the P/E ratio of the cryptocurrency itself, but only in so far as it is utilized via a business — just like we got the DCF of our $100 only as it was deposited in a savings account. We’re not getting the value of the currency itself. (Hence, this is one reason why impermanent loss can occur when depositing your crypto in a yield farming pool.)
This is extremely important since at least since the time of writing (early Jan 2023), most people relate to cryptocurrency value in terms of trading price and not in terms of yield farming on a DeFi protocol.
So, then, how to measure the AV of a cryptocurrency?
As Sebastian points out in his Lesson #5, the debate is ongoing and multi-faceted. Can we use supply-and-demand analysis, for example? Probably not since cryptocurrencies, even when capped, have vast supplies.
Back to Metcalfe’s Law?
Metcalfe’s Law is basically a way of trying to measure value in terms of an entity’s network according to the number of nodes or users active within the network.
So, for instance, if a network for Star Trek communicators has 23 red shirts, then we can determine the network value by using either of Metcalfe’s formulas.
Whereupon we would get:
- 23 (23–1)/2 = 253
Or according to the second rendition of the law,
- 23 x 23 = 529
The difference between the two variations of the law is that the latter calculates the value with a limit approaching infinity, or what would be an infinite number of users. For more detail on Metcalfe’s Law, go here.
As far as I can tell, at least in the extant literature, the latter is what tends to be cited and used when determining network value. “Metcalfe’s Law” and “n squared” tend to be synonymous.
In either case, we have a somewhat concrete way to tap into aspects of a cryptocurrency’s real value structure — that is, not its cash flow but its number of users within its ecosystem. In other words, AV = the number of nodes squared. So with Bitcoin, this might be the number of wallets or daily active addresses (DAA).
It might be. It’s a bit controversial as to whether we can reliably take DAA to represent the actual number of nodes in the Bitcoin network.
Charles Edwards considers using DAA in a 2019 Medium article and suggests that DAA is not the best way to value BTC because DAA can under- or over- estimate activity. He prefers instead the use of transaction value (TV) with a way to account for the fact that one user may be making multiple transactions. He therefore invokes another variation of Metcalfe’s Law that takes such things into the fold — i.e. Sarnoff’s Law.
Purcell (ibid.) also distrusts the use of DAA for calculating AV and points out another reason — namely, that a lot of fake addresses are created through the use of tumblers to try and hide illegal and illicit transactions. While not rejecting Metcalfe’s Law to determine AV, Purcell prefers a combination of macroeconomic and price momentum analyses, for which his algorithmic investing has become famous and is currently being used in his crypto hedge fund at 1.2 Capital.
Just to round things off for good measure, it is worth noting another study and application of a variation of Metcalfe’s Law in Timothy Peterson’s 2018 article. He concludes that Metcalfe’s Law “adjusted for the creation of new bitcoins over time” appears to accurately reflect Bitcoin’s real value. It’s complicated to calculate, so if you’re interested, see pages 12–15.
Conclusion: Using Metcalfe’s Law is a decent general indicator for absolute value. But as always, it’s those assumptions about uniformity of value and accuracy of data that make the difference.
How This Can Be Applied
Sometimes just knowing how things work and the variables that make a difference can explicitly and subtly inform a better process of reasoning and decision-making. It’s like the old G.I. Joe cartoon:
But if you’re of the ilk who wants to employ financial method and tools to assess risk and value, then you’ll be moving from the predictable and harmless world of cartoon logic to the nebulous universe of risk and unpredictability. The other half of the battle is doing.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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