Will a cryptocurrency like bitcoin grow, increase in value or disappear into oblivion? This factor decides
Ambuja Cements is a major cement producing company in India. Its market cap of Rs. 1.50 trillion reflects the capacity of its multiple cement factories, grinding plants, and machineries across India. In contrast, Zomato has a higher market cap of Rs. 1.60 trillion even though it has minimal physical assets and has consistently posted losses. Many analysts have puzzled over the fundamentals of such high market value for many new-age companies. However, to understand how Zomato is different from Ambuja Cement, one needs to appreciate how the digital economy is fundamentally different from the traditional economy.
Traditional Economy vs Digital Economy
In the traditional economy, value is created by leveraging tangible assets like labour, factories, and machinery. Companies like Ambuja Cements thrive by optimizing production and supply chain efficiency, typically operating as 'pipelines' where each stage of production adds value through physical means.#sr_widget.onDemand p, #stock_pro.onDemand p{font-size: 14px;line-height: 1.28;} .onDemand .live_stock{left:17px;padding:1px 3px 1px 5px;font-size:12px;font-weight:600;line-height:18px;top:9px} #sr_widget.onDemand .sr_desc{margin:0 auto 0;} #sr_widget.onDemand .sr_desc{color: #024d99;margin-top:10px;} #sr_widget.onDemand .crypto .live_stock .lb-icon{8px 6px 5px 3px !important} #sr_widget.crypto.onDemand a.text{border-bottom:1px solid #ccc;padding-bottom:5px;display:block;width:100%} #sr_widget.onDemand .sr_desc .text p, #stock_pro.onDemand .sr_desc .text p{font-size:12px;font-weight:400;}
The digital economy, emerging prominently over the past three decades, operates on a different model. Digital businesses, like Zomato, create value through intangible assets by facilitating connections between users, forming a network. These businesses are 'platforms' that host networks, deriving value from the network effects-the exponential increase in value as more users join.
Network Effects
Illustratively, take the case of Facebook. When it had a single user, it had no value. The single user could not add friends, nor could they like or dislike posts of others. However, as more users joined, more connections formed, and user-generated content flourished, exponentially increasing Facebook's value. Similarly, Zomato connects restaurants, consumers and gig workers on its platform, deriving its value from this growing network.Traditional pipeline companies invest in factories and machinery because the more they produce and sell, the more is their profit. They reduce their costs by producing at a scale that is most economical. Platform companies invest in growing networks, as their value is driven by network effects. Platforms spend heavily on user acquisition through marketing, free access to applications, and discounts, leading to initial losses. However, as their networks grow, their value increases exponentially, eventually surpassing the need for high user acquisition costs.
Network effects also lead to a phenomenon called 'crowding out', where dominant platforms prevent competitors from growing by controlling a vast user base. This creates monopolistic or duopolistic markets where the leading platform continues to grow effortlessly, attracting new users without significant additional costs. Once a platform attains a dominant position, new users would be inclined to join this platform over other options because they can connect with the maximum number of users on this platform only. The platform gets new users without having to spend additional money on user acquisition. The marginal cost of adding a new user becomes negligible, but each new user exponentially increases the platform's value.
Not all networks give the same effects. There are strong networks and then there are weak networks. Strong networks are dense networks spanning large geographical areas, with each connection reinforcing the network. An example is Amazon, on which consumers from across India can connect with sellers from across the country. When a seller from one corner of India sells to a customer in another corner, the network gets strengthened. Weak networks are segmented. An example is Zomato, wherein only customers, restaurants, and gig workers of one city are connected through the platform. There are just few connections among users in different cities. The value of strong networks increase more than that of weak networks with each new user acquisition. Strong networks are more resilient and valuable over time.
Platforms monetize their networks through various innovative methods, such as user data monetization or transaction commissions. Once a platform achieves a dominant market position, the cost of user acquisition drops to zero, but the incremental benefit continues, leading to super-profits.
Lifecycle of platform companies
Platform companies typically go through three stages: start-up, survival/demise, and prosperity. In the start-up stage, they have to spend money on user acquisition, so as to build their network. In the second stage, they race with their competitors to corner the largest network in the market. As crowding out happens, a few survive and others die or get merged with the survivors. Platform companies keep incurring losses at this stage. This stage is fierce, because the competition forces them to burn money aggressively, but they can run out of fuel if investors stop pumping working capital. Finally, in the prosperity stage, the platform enjoys market dominance, reaping super-profits and recovering past losses.Estimating the value of a traditional company is quite straightforward. Depending on the capacity of its factories, machinery, and human resources, and market demand for its goods and services, its profits can be estimated. Its expected profits in future years determine its present value. But because the digital economy is fundamentally different from the traditional economy, valuing digital platforms involves understanding the structure of their user network, user acquisition strategies, lifecycle costs, and competition strategy. This complexity often puzzles analysts when comparing companies like Ambuja Cements and Zomato.
Role of network effects in value of crypto assets
Interestingly, the most valuable crypto assets on today's date also command value due to network effects. While there have been wide fluctuations in the price of Bitcoin, the value of Bitcoin and Ethereum (the two most popular crypto assets today) have increased consistently over the years because of rise in the number of users (see figure). Hence, the value of Bitcoin increases as more people consider it valuable!Many people believe that Bitcoin is valueless because it has no underlying value. Such naysayers do not influence the value of Bitcoin; those who believe in it determine its value. This is the power of network effects. In fact, gold also does not have any intrinsic value but is costly because of network effects. It took gold thousands of years to gain the network effect to become the 'gold standard', but Bitcoin has gained significant network effects in a matter of a decade because the internet enables networks to develop and grow fast.
Figure 1: Consistent rise in number of investors in Bitcoin and Ethereum over the years is matched by overall rise in their value (Source: Coinmetrics, quoted in Swain (2024))
It is important to understand network effects because it is the singular force that drives economic value in the digital economy, as opposed to the traditional economy.
(The author is director in the Department of Revenue, Finance Ministry and author of the book 'Digital Fortunes: A Value Investor's Guide to the New Economy (Bloomsbury, 2024)'.)
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This story originally appeared on: India Times - Author:Faqs of Insurances
