Tools

What is Facebook worth? Its value has fluctuated wildly. Only founded in 2004, a deal with Microsoft in October 2007 seemed to put it at about $15bn. By the summer of 2008, Business Week was reporting that shares were being sold privately at prices implying that Facebook was worth less than $5bn.

Business fashions come and go. But the uncertainty over the valuations of networking sites such as Facebook and MySpace is not surprising to an economist. Their value, presumably, has something to do with the number of connections they make possible.

It is not hard to count them. Computer whiz Robert Metcalfe even proposed in 1980 that the value of a network is proportional to the square of the number of users (or devices) on it, reasoning thus: a single fax machine is useless. A pair can make a single connection… five can connect ten ways. Because each new fax machine can talk to any of the existing machines, each new one is worth more than the last.

Metcalfe invented the Ethernet standard for computer networking and went on to become a high-tech entrepreneur and venture capitalist. Yet, while the maths of his law is indisputable, its economic logic is debatable. That matters because, while Metcalfe conceived of his law as applying to small Ethernet networks, it has often been uncritically applied to much larger networks — notably during the dotcom bubble.

The problem is that not every connection is equally important. The first telegraph linking Europe and the US was hugely valuable. The ability to fax the next cubicle is not. When Microsoft bought a slice of Facebook, it had about 90 million users: 4,000 trillion two-way connections were possible, but few will ever be useful.
For economists, the value of a network also depends critically on the ease with which people can switch to another network. Fifteen years ago it would have been inconceivable for everyone to scrap their fax machines. 

Yet it is not so hard to imagine Facebook’s users deserting in droves for the next big thing in social networking. And a network that can be abandoned overnight is a network whose value can be destroyed overnight, too.

Financial Times columnist Tim Harford is author of The Logic of Life

• Tweet