Facebook (NASDAQ:FB) has significantly improved its monetization over the last few quarters, especially on its mobile platform. Its advertising business is getting support from a growing number of marketers, rising advertising demand and the success of news feed ads. It is interesting to note that the company is on track to claim roughly 5.4% share of the global online advertising market in 2013, up from 2.6% just three years ago. We expect this figure to reach nearly 8% by 2016, implying close to $13 billion in annual ad revenues for the company.
If Facebook can increase its share of the global online advertising market to 12% instead, we estimate that there could be a massive 50% upside to our current price estimate. In fact, the current stock price suggests such lofty expectations from the market. 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).
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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
Facebook’s ads are highly effective, 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 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.
International Markets Hold Big Opportunity
Despite the fact that international markets account for more than 80% of Facebook’s active user base, they constitute less than 50% of its total revenues due to low monetization. There exists a big opportunity here for the company to boost its ad business.
In Q2 2013, while ARPU (average revenue per user) for the U.S. and Canada stood at $4.32, the same figure totaled $1.87, $0.75 and $0.63 for Europe, Asia and Rest of the World respectively.  The chart below shows the trend in ARPU for different regions, and it appears that the gap between the figures for the U.S. and international markets has widened. We believe that this may be due to Facebook’s ramp-up of mobile advertising which has garnered immense success domestically, where several marketers have launched their marketing campaigns on Facebook’s mobile platform. Over time, we expect this gap to narrow.
Average Revenue Per User (Source: Facebook’s SEC Filings)
During the second quarter of 2013 , global ARPU stood at $1.60, registering 25% growth over the same period last year.  In comparison, U.S. ARPU growth was 30% which indicates that Facebook expanded rapidly in areas with lower ARPU. It is highly likely that the user growth will continue to be high in these markets, and overall ARPU may increase at a slower rate. However, going forward, the company has an opportunity to improve ad pricing and sell more ads in international markets as the global economy recovers, the quality and quantity of data generated by international users increases, and e-commerce sees greater adoption.
Video Ads Could Further Boost The Business
Facebook is planning to experiment with video ads later this year and has been working with advertisers to figure out the right strategy.
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.
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%. However, these sales might not be completely incremental and may cannibalize some of its revenues from display ads.
Our price estimate for Facebook stands at $30, implying a discount of about 35% to the market price.Notes: