What If Average Ad Pricing Continues To Increase Rapidly On Facebook?

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Advertising on Facebook‘s (NASDAQ:FB) core platform accounts for the dominant share (around 70%) of its  valuation, in our view. While both the user base and average revenue per user (ARPU) represent the key drivers in this business, we believe increasing ARPU is the most important factor, accounting for around-70% of the overall growth. The ARPU metric is further dependent on growth in ad pricing, as well as in the number of ads delivered. We expect average ad pricing to improve over the coming years, driven not only by ongoing efforts to improve ad quality and targetability, but byt the secular trend towards mobile advertising. So what happens if the average ad pricing grows by 15% CAGR over our forecast period (2015-2021), instead of our present estimate of 9% CAGR growth? The valuation increases by 20% to $127. To help our readers assess the impact, we have created a mini interactive model, where users can vary average ad pricing growth to see the change in average revenue per user forecast (refer to grid view on top right corner of the link to see all drivers and output). Readers can then leverage this forecast to apply it in our valuation model for Facebook to see the impact on price estimate.

Our $109 price estimate for Facebook’s stock, is almost at par with the current market price.

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See our complete analysis for Facebook

What Could Happen If Facebook’s Average Ad Pricing Rises By 15% CAGR over 2015-2021?

During the past several quarters, Facebook’s average ad pricing grew significantly as the social networking platform switched to more-prominent (but fewer) feed-based ads. The average ad pricing is expected to continue increasing in the future, and our base forecast incorporates 9% compound annual growth rate of the same over our review period (2015-2021). Nevertheless, the recent moves to roll out video based ads, and improve the quality and relevance of ads, could lead to upward revision of these estimates. So what happens if CAGR in average ad pricing rises as high as 15% till 2021. This figure below demonstrates the change, as follows:

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1) the 15% CAGR in average ad pricing will cause Facebook’s global ARPU to rise from $9 in 2014 to $30 in 2021 (earlier the same was earlier pegged to increase to $22 by 2021).

2) Additionally, this scenario causes the compound annual growth rate in Facebook’s global ARPU during 2015-2021 to increase from base-case rate of 12.2% to 18.8%, representing nearly 660 basis point rise.

3) As ARPU is the most important factor driving growth in the Facebook’s core-advertising business, our valuation model estimates the above mentioned scenario could lead to around 20% upside to our current price estimate.

What Could Trigger Such Growth In Average Ad Pricing?

We think the average ad prices could rise much higher than our current estimates, due to the following reasons:

1) Improvement in the quality of ads: We believe Facebook’s efforts to  drive more video views on the platform, which recently surpassed 8 billion daily, will lead to corresponding growth in ad pricing on the platform. This is as video ads command higher pricing than other forms of ads. Further, we believe continuous innovation in ads will make them more engaging in the future, driving up overall pricing.

2) Improvement in the measurability and target-ability of ads: Another factor that directly influences the price of ads is their relevance. Because Facebook posses such large amounts of data on users’s interests and preferences, the company will be able to accurately improve the target-ability of ads.

3) Solid Demand For Advertising On Facebook: More than 40 million businesses globally have Facebook Pages, which help them market to the 1.5 billion monthly active users on the platform. Out of these, only 2.5 million are active advertisers on the platform. We believe these numbers will surge over the coming years, as engagement continues to rise on the social networking platform. This increased demand will further buttress ad pricing, in our view.

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