Analyst says 94% of bitcoin's price movement over the past 4 years can be explained by one equation

The FundStrat cofounder Tom Lee says: "If you build a very simple model valuing bitcoin as the square function number of users times the average transaction value, 94% of the bitcoin movement over the past four years is explained by that equation."
This model is based on Metcalfe's law, which says the value of a network is proportional to the square of the number of users on the network.
Bitcoin has been trading at a level above the price projected by the model. FundStrat remains positive on bitcoin in the long term but sees the risk of a short-term correction increasing.

Tom Lee, the cofounder of FundStrat Global Advisors, is bullish on bitcoin and has a unique way of valuing the cryptocurrency.

He says his short-term valuation model, built on Metcalfe's law, can explain the majority of bitcoin's volatility. He explained his reasoning on Business Insider's cryptocurrency show, "The Bit."

Metcalfe's law says the value of a network is proportional to the square of the number of users on the network.

For example, a fax machine is utterly useless if you are the only one who has one, but the value increases exponentially as other people get fax machines.

This is also true for social networks — Facebook is valuable because so many others are on it. It'd be a boring place to surf alone.

"If you double the number of users, you're more than doubling the utility value," Lee said.

Lee says the same is true for bitcoin. FundStrat looked at unique addresses as a proxy for users on the bitcoin network and found that the square of this value explained 63% of the variation in bitcoin prices since 2013.

Here's the portion of "The Bit" that explains his thinking. You can watch the full interview with Lee here.

Lee: In the short term, we think bitcoin has really followed very closely the idea of acting like a social network — meaning the more engagement there is, the greater the value rises. And in the short term, we think bitcoin will reach at least $6,000 by mid-2018.

Sara Silverstein: And you're using Metcalfe's law. Can you explain that?

Lee: So Metcalfe's a professor. He actually came up with a theorem based on George Gilder, which is the value of a network is the square of the number of users. And so if you build a very simple model valuing bitcoin as the square function number of users times the average transaction value, 94% of the bitcoin movement over the past four years is explained by that equation.

FundStrat expanded its short-term model by adding the bitcoin transaction volume per user. This linear factor explained 83% of the variation in bitcoin's price.

FundStrat found a formula by regressing the price of bitcoin against both unique addresses squared and transaction volume per user. This model explained 94% of the variation in the cryptocurrency price since 2013.

The chart below plots the projected price of bitcoin based on this model (light blue) against the actual price (dark blue dotted line). The model has a relatively good fit through the middle of this year.

FundStrat can then use this model to project the future value of bitcoin. The model requires an estimate of the number of unique addresses on the bitcoin network (squared) and an estimate of the number of transactions a day.

Lee says the model provides "a method to suggest a short-term range for bitcoin." Given this premium, Lee is a little more cautious in the short term.

"Bitcoin's longer-term technical trend remains positive," he said, "but short-term upside appears limited, and the risk of a correction is growing."