Social Advertising Is Facebook’s Backbone And Drives $33 Stock Value

Facebook is the largest social network in the world with more than 900 million monthly active users. It competes primarily with much smaller competitors like Google+, Twitter, LinkedIn (NYSE:LNKD) and Pinterest in the social networking space, and with Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT) and Yahoo (NASDAQ:YHOO) for online advertising dollars. Facebook made a net profit of close to a billion dollars in 2011, which is expected to grow further going forward.

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Facebook makes money primarily from text and display ads and virtual transactions on its platform. Here we look at how the text and display ad business work:

Advertising: Facebook’s Lifeblood

Facebook offers a self-serve advertising platform for advertisers, which enables them to create text ad units and target them to users based on their social demographic data. Since Facebook has a treasure trove of information about almost its entire user base, Facebook can offer advertisers some of the best targeting capabilities like age, sex, location, keywords, education level, workplaces, political views and relationship status.

It is also rolling out new types of display ad units like custom fan pages, sponsored stories etc. Facebook makes money based on how many pages are visited and the rates on which these advertisements are bid for. Facebook offers both Cost per Click (CPC), for which advertisers pay only when users actually click on the advertisement, and Cost per Thousand Impressions (CPM), for which advertisers pay based on the number of times these advertisements are displayed on user pages.

Facebook’s advertising revenue depends primarily on its average monthly unique visitors, which we expect will increase to more than 2 billion by the end of the forecast period, almost double the number right now.

It also depends on the number of page views per user per month, which has historically been quite high considering the high level of engagement on Facebook, and is expected to increase further going forward as Facebook improves on its mobile offerings and initiatives like Facebook Connect drive further traffic to its platform.

Finally, it depends on the average revenue generated per active Facebook user. While the average revenue metrics have show a significant increase in the last couple of years, the growth is expected to slow down going forward as more users start logging in to the platform through Facebook’s mobile apps. Monetizing mobile is going to be a tough nut to crack, but we expect Facebook to figure out the mobile monetization puzzle eventually.

Text and display ads account for a majority of Facebook’s overall revenue and around 75% of its overall $82 billion Trefis valuation.

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