Facebook (NASDAQ:FB) has significantly improved its advertising business over the last few quarters, especially on the mobile platform. The company’s stock has surged by roughly 45% post its Q2 2013 earnings announcement that reflected strong ad revenue growth. The business is getting support from a growing number of marketers, growing advertising demand and the success of news feed ads. Direct response marketers have increased their advertising spend on Facebook because of the high click-through rates that they are seeing on the social network. These advertisers are measurement-focused, and it appears that Facebook’s targeted ads are delivering attractive return on investment (ROI).
Where does the company go from here? It is imperative to consistently improve efficacy, style and mix of advertisements that are rolled out to the users. On this front, Facebook is planning to experiment with video ads later this year and has been working with advertisers to figure out the right recipe.
Facebook’s video ads will be roughly 15 seconds long, which is smaller than the ad slots typically sold on TV networks. To roll out these ads to all its users, the company will charge about $2 million a day to an advertiser.  That may seem like an outrageous amount, but the company may justify it on its global reach and a much bigger user base compared to the viewership that any TV network garners. However, with this new feature, Facebook runs the risk of adversely impacting user experience and potential disinterest from marketers who may not agree to pay such a high fee while also trying to squeeze the commercial in just 15 seconds. It is too early to make any judgement, and a lot will depend on how fast these video ads load, how often they are fed to users, their aesthetics and utility.
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The advertisers are likely to roll out their video ads to a specific demographic, and so we expect the actual fee charged per advertiser to be much lower than $2 million per day. Even if we assume that Facebook manages to earn a total of $2 million per day from all the advertisers combined, it would imply $720 million in incremental annual revenues. This could lead to upside of about 10% to our price estimate. If the same figure amounts to $10 million per day, the upside could be as high as 35%. Please note that these sales might not be completely incremental and may cannibalize some of its revenues from display ads.
How Video Ads May Be Integrated On Facebook?
According to Facebook, the video ads will automatically play without any sound and a user can tap the ad to restart it and enable audio. The company also said that the user will see ads from only one advertiser per day and may see ad content from the particular advertiser up to three times a day.  This limitation is essential as Facebook attempts to find a balance between keeping the users happy and taking advantage of the opportunity that exists in the online video ad market.
According to eMarketer, a research firm focused on digital media and e-commerce, advertisers are expected to spend $66.4 billion on TV ads in the U.S. in 2013, compared to just $4.1 billion on online video ads.  The latter figure still represents growth of 40% over 2013 which suggests that this business may get a big boost in the coming years due to the ability to target specific customer groups.  This is a unique value proposition offered by Facebook which analyses data gathered from the activity of its users to target ads more effectively.
How Effective Are Facebook’s Ads?
Facebook 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. For instance, the company launched a huge mobile advertising campaign for Wal-Mart (NYSE:WMT) during the holiday season and around 50 million ads focusing on deals and discounts were rolled out to millions of Facebook users.
Facebook’s efforts 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. Certain measures suggest that the effectiveness of advertisements on Facebook’s social networking platform is growing and that bodes well for the company’s future.
A Facebook study shows that Bud Light’s ads, which were posted on its Facebook page, were highly effective. These ads reached 20% of U.S. households and improved sales by 3.3%, offering a six times return on the ad spend.  Another study showed that when measured holistically, the cost per acquisition on Facebook is 68% less than the cost on other online channels.  The company’s ‘custom audience’ product, which basically combines user data and advertisers’ customer data to increase the effectiveness of the ads with improved targeting, is seeing good traction.
Our price estimate for Facebook stands at $30, implying a discount of about 20% to the market price.Notes: