Why Investors Should Think Twice Before Buying Facebook Stock

by George Riley
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Submitted by George Riley as part of our contributors program.

Facebook’s (FB) recent share price rally presents those investors who bought in at the company’s IPO with a dilemma. At its current price of $37, should they take the opportunity to sell out even, or hold for further gains?

Industry

The three main players in the online advertising industry are Google (GOOG), Facebook and the Microsoft (MSFT) and Yahoo (YHOO) partnership, Yahoo! Bing. Google currently controls the market; analysts expect it to draw 33.2% of the $117B total digital ad spend this year. The same analysts expect Facebook to draw 5.0%, and Yahoo! Bing, 4.8%.

To justify further upside in its share price Facebook must challenge Google’s dominance in the industry. To do this, it must offer an effective alternative to Google’s offerings. Investors should ask themselves, does advertising on Facebook offer advertisers better results than on Google or Yahoo?

Comparison

There are three main criteria against which to measure the effectiveness of online advertising. These are click through rate (CTR), cost per click (CPC) and total reach.

CTR measures the amount of times a user clicks on an ad in relation to its displays. The table below shows the CTR of ads displayed on Google, Yahoo! Bing and Facebook.

Site                                   CTR

Google.com                        2%

Yahoo.com/Bing.com      0.93%

Facebook.com                    0.05%

The results show that Facebook users are much less likely to click on an ad than users of Yahoo! Bing or Google. Why is this? The disparity in CTR stems from user intent. Google or the Yahoo! Bing network users are much further along the buying cycle than Facebook users. Around 10% of searches on Google are transactional, meaning that they directly relate to an intent to buy a product or service. Following a transactional search, clicking on an ad that contains that product or service is a natural progression. In contrast, users of Facebook are on the site for social interaction. Clicking on an ad draws them away from their current focus.

CPC measures the amount an advertiser pays each time a user clicks on an ad. The table below shows the average CPC of ads displayed Google, Yahoo! Bing and Facebook.

Site                                    CPC

Google.com                       $0.82

Yahoo.com/Bing.com     $0.86

Facebook.com                  $0.80

This time the CPC results favor Facebook. On average, advertisers pay less for a click from a Facebook user than they do for a click from a Google or Yahoo! Bing network user. The assumption here is that this again relates to user intent. Advertisers recognize the disparity in CTR, and the amount they are willing to pay reflects this.

Finally, it is possible to measure the potential reach of an ad by comparing the user base of the sites in question. The monthly active user (MAU) count is a summation of each sites daily count of unique users over thirty days. The table below shows the MAU count of Google, Yahoo! Bing and Facebook according to Quantcast, as of June 2013.

Site                                  MAU

Google.com                      184M

Yahoo.com/Bing.com    141M

Facebook.com                  136M

Once again, Google comes out on top, with a potential monthly user reach 35% higher than that of Facebook.

Summary

Fewer people see, and click on, Facebook ads than they do Google and Yahoo! Bing ads. To answer the original question, they do not offer better results than the alternatives provided by Facebook’s competitors.

This does not mean that Facebook has no potential for growth; the online advertising industry is growing and Facebook will likely attract revenue from this growth. It does mean however, that the company must improve the effectiveness of its ads if it is to draw market share from Google.

Native Ads

One thing favoring Facebook growth is the company’s recent adoption of native ads. Native advertising integrates promotional content with standard content, and adopts the look and feel of its host site. Delivered in-stream, native ads do not interrupt the user’s experience. An example of this is Facebook’s news feed ads. The CTR of native ads is between 2% and 5%. However, Facebook is not the only company deriving benefit from native advertising. The company faces competition from a number of platforms that serve as a marketplace for native advertising transactions. One company that runs a number of these platforms is IZEA, Inc (IZEA). IZEA’s current platforms include Sponsored Tweets, which facilitates native advertising through Twitter; SocialSpark, which facilitates advertising via blogs; and Staree, which allows publishers to promote via photo sharing. Towards the end of 2013, IZEA will add Native Ad Exchange (NAX) to this list. NAX is a multi-country, multi-language platform that will bring together advertisers and content publishers and provide access to many of the main social media channels, including Facebook. This poses a threat to Facebook, as when a publisher places a native ad on Facebook via platforms like NAX only the publisher and the platform provider, in this case IZEA, will receive payment. Facebook stands to gain nothing from the transaction.

Conclusion

Facebook’s display ads are relatively ineffective. This suggests that the company is unlikely to draw much market share from its competitors in that particular area of online advertising. This may change however, as the focus of the online advertising industry shifts from display ads to native ads. Analysts suggest that native advertising spend could overtake display advertising spend in the next 2-3 years. When it does, the upside potential of Facebook’s share price will depend on its ability to compete with platforms like NAX for online advertising dollars.

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