Ethereum (ETH -1.28%) is up a resounding 37% so far this year. That might sound impressive, but keep in mind that Ethereum is still trading at nearly the same level it was 12 months ago when it completed The Merge. Shouldn't Ethereum's price have soared after this much-hyped technological breakthrough?
Clearly, crypto investors aren't impressed by technical upgrades and are waiting for the next big catalyst to appear for Ethereum. But that next big catalyst might be right under their noses, and they aren't even aware of it yet. As a result, Ethereum could be massively undervalued at its current price of $1,645.
Layer 2 blockchain activity
The one metric to keep an eye on is the amount of activity happening on Layer 2 blockchain networks. These Layer 2 blockchains are built directly on top of the main Ethereum network, and help make Ethereum run faster, more efficiently, and more affordably. As such, they are very much part of the broader Ethereum ecosystem, and should be taken into account when thinking about Ethereum's growth prospects.
Even after The Merge, Ethereum needs these Layer 2 blockchains, and founder Vitalik Buterin has always been clear that he supports the development of these Layer 2 networks. They are not cannibalizing the future growth of Ethereum. Instead, they are actively contributing to a much faster rate of growth for Ethereum.
To give you an idea of just how important these Layer 2 blockchain networks are, there are now five that rank among the top 55 cryptocurrencies by market capitalization. Granted, many of them are hardly household names. With the exception of Polygon, which garnered a fair amount of attention around the time of The Merge, they are quietly working behind the scenes, helping to scale Ethereum.
Impact on growth
These Layer 2 blockchains are directly contributing to Ethereum's market dominance in key areas. For example, take non-fungible tokens (NFTs). If you examine the 30-day sales volume for NFTs, Ethereum is still the clear leader, with just under $200 million in sales. The next biggest Layer 1 blockchain network is Solana, with just under $30 million in sales. So, as a quick approximation, it's possible to say that Ethereum is doing nearly 7 times the sales volume of its next closest competitor.
However, two of the top blockchains for NFT sales volume are Immutable X and Polygon, and both of these are Layer 2 blockchains for Ethereum. When you add in the 30-day NFT sales volume for both of these (approximately $50 million total), then it's possible to say that Ethereum is doing 8 times or even 9 times the sales volume of its next closest competitor.
Image source: Getty Images.
And the same story is true in the decentralized finance (DeFi) market. Again, Ethereum is the clear market leader here, accounting for nearly 55% of Total Value Locked (TVL). This metric describes how much value is "locked up" in various DeFi protocols, and is the single best indicator for overall DeFi strength. But four Layer 2 blockchains also rank in the Top 10 for TVL, and these account for another 10% of TVL on an aggregate basis. Taking this into account, Ethereum is responsible for a staggering two-thirds of all TVL in the blockchain world.
Valuation models
As demonstrated above, taking into account Layer 2 blockchain activity shows just how much Ethereum is potentially undervalued. A new report from crypto research firm RxR came to a similar conclusion. Using a valuation model based on Metcalfe's Law, which states that the value of any network is directly proportional to the square of the number of users, the research firm suggested that Ethereum might be undervalued by as much as 27%. In short, investors are overlooking the massive user growth on Layer 2 blockchain networks, and that is causing them to undervalue Ethereum.
Granted, there are bound to be some skeptics who think that Metcalfe's Law shouldn't be applied to cryptocurrencies. After all, it's inconclusive whether adding a new user to an existing blockchain network should lead to a huge increase in value. It's different in the case of, say, telecom networks, because it's immediately clear how each new user (i.e., the person paying the phone bill each month) can be monetized.
Moreover, Metcalfe's Law can lead to some pretty dizzying price estimates for cryptocurrencies. During the last crypto bull market rally, models based on Metcalfe's Law were projecting a $20,000 price target for Ethereum. The all-time high for Ethereum is just under $5,000, so that price target was wildly off the mark.
So is Ethereum undervalued or not?
Still, it's easy to see how Ethereum could be significantly undervalued. Ethereum's metrics seem to be flatlining or declining. But dig deeper, and you'll see Layer 2 activity is taking off. The big question you have to ask yourself as an investor is whether this Layer 2 activity should be additive to the overall value of Ethereum.
It might be a controversial take, but I'm firmly in the camp of investors and analysts who think that Ethereum is trading at a huge discount right now. There's just too much activity happening on Layer 2 blockchain networks to ignore.
