Online-based businesses benefit greatly from Metcalfe's Law of Networks and the Zero/Infinity Advantage. Both of these paradigms demonstrate that a leading networked business may create continually growing value with decreasing effort and decreasing costs over time. These powerful dynamics could eventually cause the stocks of leading online businesses (such as priceline.com and a few others) to return to favor.

By Jeff Fischer (TMF Jeff)
July 27, 2000

You have heard of the network effect, economies of scale, and Moore's Law, all of which play key roles in the performance of many (if not most, when it comes to economies of scale) businesses. In the online world, two other factors are important to understand: Metcalfe's Law of Networks and the Zero/Infinity Advantage.

Metcalfe's Law of Networks
Metcalfe's Law of Networks states that the value of a network grows by the square of the size of the network. Translated, this means that a network that is twice as large as another network will actually be at least four times as valuable. Why? Because four times as many interconnections are possible between participants in the larger network.

When you add a fourth person to a group of three, you don't add just one more networked relationship. You add several. The new individual can network with all three of the existing persons, and vice versa. The Internet is no different. It became more and more valuable as the numbers of computers using it grew.

Because the value of an interactive network grows by the square of its size, online-based businesses can create value much more quickly, via various means, than can off-line businesses that also need to conduct communication or trade. And due in part to Metcalfe's Law of Networks, the largest online networks will almost always win -- creating more and more value over time. They tend to win at the expense of smaller networks that see their users flee to the larger, more valuable networks.

Zero/Infinity Advantage
Typically working hand-in-hand with Metcalfe's Law is what CIBC calls the Zero/Infinity Advantage. (A CIBC World Markets report is the only place I've seen this concept mentioned.)

According to the Zero/Infinity Advantage, a successful network-centric business will have costs that trend lower and lower towards zero even as additional value-creating parties join the network. Meanwhile, the potential benefits of the network will rise towards infinity. We'll use online auction house eBay (Nasdaq: EBAY) as an example. This example was explained in more detail in our initial Motley Fool Research report on eBay and in our Internet Report covering online auctions.

In the online auction business, the long-term (lifetime) market size is essentially unlimited, meaning that the market size may slowly grow towards infinity -- perhaps eternally doing so -- while the incremental costs for the leading auction hosts will, in relation to the growing market, shrink towards zero. Our table demonstrates this dynamic.

Zero/Infinity Advantage with Online Auction Businesses

    Moving Towards Zero        Moving Towards Infinity

                               Potential customers--->
                               Potential auctions--->
                               Potential commissions--->
                               Potential variety of products offered--->
<---Cost per auction hosted
<---Cost of user acquisition
<---Cost of branding
<---Cost of incremental growth

Source: CIBC World Markets and Motley Fool Research Report on eBay

Conclusion
Online businesses that are able to leverage Metcalfe's Law of Networks and the Zero/Infinity Advantage stand to create growing shareholder value. To do so, these companies need only to continue to operate efficiently and to attract a consistent stream of new users. Luckily, Metcalfe's Law of Networks can do much of the "attracting" of new users for large networks automatically.

Yahoo! (Nasdaq: YHOO), eBay, priceline.com (Nasdaq: PCLN) and even Amazon.com (Nasdaq: AMZN) already benefit from immense networks of users who attract more and more additional users. Yahoo!, eBay and priceline could stand to benefit most overall because these companies don't carry inventory. These companies are, in essence, network businesses alone.

Although online-based stocks are out of favor, in the long run the companies with the best online business models (and, one could argue, with the best possible models anywhere) will return to favor. The financial performance of these network leaders should one day merit a turnaround in sentiment. Priceline will likely be profitable within six months, due largely to Metcalfe's Law and the Zero/Infinity Advantage. The stock is hitting new lows, however, showing just how out of favor these companies are. That won't last forever.

Your Turn:
Which companies do you see taking advantage of Metcalfe's Law of Networks and the Zero/Infinity Advantage?

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