Facebook (NASDAQ:FB) recently announced that it will roll out advertisements on its photo sharing service, Instagram, which it acquired last year for $1 billion in cash and equity.  That’s good news for the investors who have shown confidence in the company’s stock ever since it started showing meaningful advancements in terms of ramping up the mobile advertising business. Facebook is getting support from a growing number of marketers, rising advertising demand and the success of news feed ads. To make a meaningful contribution, Instagram’s monetization level will need to be closer to that for Facebook in the North America region. But this is going to take some time.
Facebook’s current stock price suggests lofty expectations from the market. Our price estimate for Facebook stands at $30, implying a discount of about 40% to the market price. There are certainly some reasons to be optimistic about the stock, but there are risks to be considered too (read Key Risks For Facebook As Stock Continues To Climb).
How Much Value Can Instagram Add?
Instagram currently has over 150 million monthly active users.  In June 2013, the service had a total of 16 billion photos with 1 billion likes per day. That makes it the biggest photo sharing service in the world offering tremendous monetizing potential for Facebook. The company will slowly ramp up the ad density, and experiment initially with the type of advertisements that gel well with the content. A parallel can be drawn with its ramp up of mobile monetization, where the feed-based ads were successful and solved the issue of not having enough space on mobile screen to place ads.
In Q2 2013, Facebook’s monthly active users on mobile reached 819 million, implying growth of 50% over the same period a year ago. In addition, the company’s overall advertising revenues swelled 61% over Q2 2012, amounting to $1.6 billion. Mobile advertising revenues represented about 41% of the company’s overall advertising revenue for the same period. This implies that average ad revenue per user on mobile stood at 80 cents during the quarter. If Instagram can do something similar, Facebook can add $120 million in incremental revenues, which can grow over time as the number of users and ad pricing/density on Instagram increase. This is rather a small amount when seen in the context of $6.35 billion in ad revenues that we expect Facebook to earn in 2013.
To make a meaningful difference, the monetization level on Instagram will need to be closer to what Facebook has in the U.S. and Canada. At $4.32 per user, which was Facebook’s average revenue per user in Q2 2013 in the U.S. and Canada, Instagram can lift the company’s ad revenues by roughly 10%.
Instagram is one of the many ways Facebook is trying to boost its global advertising business. The last two quarters have been very encouraging on this front as the company improved its mobile ad business significantly. Facebook’s share in the overall online advertising market continues to go up, and there is still a lot of room for growth as we discuss below.
How Is Facebook’s Share Of Online Advertising Market Growing?
Global digital ad spending stood at $102.8 billion in 2012, up from $72.4 billion in 2010.  More marketers are opting for digital ads as online advertising is cheaper and more targeted, thus offering better returns on investment. The total spending through this channel is expected to top $163 billion in the next few years. While North America will continue to account for the majority of this market, Asia and Africa will emerge as new growth avenues.
Facebook will continue to be at the forefront of this growth. The company has increased its share of the global digital advertising market from 2.6% in 2010 to 4.2% in 2012. By 2016, we expect this figure to reach almost 8% as Facebook continues to experiment with new ad formats such as video ads, increases user engagement, gains higher leverage in negotiations due to its highly targeted approach, and expands internationally. However, our price estimate can jump by 50% if this share was to increase to 12%, implying annual ad revenues of $20 billion.
Highly Effective Ads Are Fueling Facebook’s Growth
The growth is being fueled by high efficacy and specificity of Facebook’s ads, which is why advertisers are diverting more of their marketing budget towards this platform. The company earlier stated that an analysis by Datalogix of 55 ad campaigns on Facebook over the span of six months suggested that the advertisers’ median ROI was much higher when their campaigns included feed-based ads.  Mobile is becoming an integral part of these campaigns.
Facebook’s effort to make its ads more engaging is driving ROI higher for advertisers. The company is also leveraging a vast amount of user data to help advertisers reach the right audience. The effectiveness of advertisements on Facebook’s social networking platform is growing and that bodes well for the company’s future.
Our price estimate for Facebook stands at $30, implying a discount of about 40% to the market price.Notes: