How Does Facebook Make Money? - October 2014

Facebook stock (Nasdaq: FB) has surprised many critics by climbing an impressive 40% so far in 2014, and more than 100% since it went public in May 2012. To understand what's fueled this rise, we answered a key question: "How does Facebook make money?"

Money Morning E-commerce Director Bret Holmes has known for a long time...

how does facebook make money
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You see, Holmes uses web advertising across multiple social media platforms as part of his job here at Money Morning. And with Facebook's 1.3 billion monthly active users - more than any other social media site - its advertising model is a key component of his work.

"Social media companies are legitimate advertising websites, no different than, say, Google or Yahoo," Holmes said. "Except users have a much different relationship with Facebook. FB functions like a family - it knows a lot about you, you're constantly interacting. Google is more like your neighborhood - it's there when you need it, but you don't need it every day."

The trick for social media companies like Facebook profiting as ad platforms is finding the best way to insert advertising into this "family-like" user experience without impacting the user in a negative way.

And that's a trick that Facebook figured out in 2013...

Facebook's "Cinderella Story" Is All About the Advertising

We all remember that Facebook's 2012 IPO was an unmitigated disaster. It lost over half of its value within six months of listing, and was priced at 107 times trailing 12-month earnings, making it pricier than 99% of all companies in the S&P 500 at the time.

But its rebound - the Facebook stock price more than doubled from July through September 2013 - stemmed from advertising.

"Facebook has gotten really good at advertising. It's inexpensive and it's smartly done," Holmes said. "When Google first started, it wasn't good at advertising, and look at them now."

Facebook has made two changes to unlock its value and become what Holmes described as "the most advantageously competitive product on the market for advertisers, hands down"...

The first thing it did to turn performance around was it developed a new advertising format in early 2013.

You see, Facebook originally started with space ads. Then, it gave advertisers the ability to promote an individual's or a company's Facebook page. But things were still sluggish.

The new format it implemented is technically referred to as "native social ads" - ads that are seamlessly integrated into the social media's platform. BIA/Kelsey projects social media native revenue as the fastest-growing social media advertising method at a 38.6% CAGR by 2018.

"Facebook has integrated in-stream ads to the user experience. Response rates are high and advertisers will always chase the least expensive ad with the best response," said Holmes.

In-stream ads can be videos. For instance, a commercial will appear before the user may watch an Internet video. On a social media site like Facebook, which has real-time update feeds, in-stream ads can be inserted into a streaming feed. So, for example, the user scrolls through the News Feed to see what friends and family are up to, and in-stream ads are peppered into the Feed.

"For the first time in 2013, Facebook let advertisers access FBX, an ad exchange where you can customize your own ads," explained Holmes. "Now we can glean information and better target our audience. We can also advertise on mobile now."

Advertisers began flocking to the site, and earlier this year, the company revealed it had more than 1 million working within it.

Now, Facebook makes more than $1 billion a quarter in ad revenue. Annual revenue by year increased from $5.09 billion in 2012 to $7.8 billion in 2013. According to Gizmodo data from earlier this year,FB rakes in roughly $15,152 of revenue every 60 seconds, with $2,887 of that coming in as profit.

The amazing thing is, that's nothing compared with what's about to come.

The second change FB made just came on Sept. 29. The company launched a new platform that's going to revolutionize web advertising - and "it's going to make Facebook an absolute juggernaut"...

Facebook's Revolutionary "Atlas" Revamp

Last week, FB announced it rebuilt its "Atlas" ad platform and released it for beta testing.

Before the new Atlas, the company used cookies to track what websites you visit, and then it would serve users targeted ads on its site. The revamped version allows tracking on mobile - making available huge datasets that weren't accessible before. It also gives advertisers feedback (like what percent bought a product based on a certain ad that ran on Facebook).

But really, the new Atlas is a big deal because it delivers people-based marketing instead of content-based marketing. What that means - and why it's so revolutionary - is best explained by comparison.

Take Google (Nasdaq: GOOG, GOOGL). The company uses two things to serve people targeted ads: content and search history. While your web page content and the searches you're inputting are good resources to serve targeted ads, it pales in comparison to the personal data Facebook takes into account.

"For Google ad targeting, it's sort of like trying to define you by the letters you receive in the mail - your L.L. Bean catalogues and whatnot," Holmes said. "But for Facebook ad targeting, it's more like interviewing your grandparents, your friends, the restaurants you eat in - all of your daily activities."

If you use Facebook to log into apps (think Instagram, Pinterest, and Foursquare, to name a few) all that data is game too.

Of course, the better the targeting, the more effective the ads.

"Now imagine you're going to that shopping mall, but it already knows the exact three stores you need and when you get there, those are the three up front. That's how the new Atlas works," Holmes said.

And that's why Atlas is a game changer for web advertising - and for Facebook.

Here at Money Morning, we have a penchant for tracking down the best stocks to buy based on independent, thorough research and our seasoned experts' know-how. And right now, we've pinned down two social media stocks to buy that come from China. The country's surging e-commerce industry - expected to be worth $540 million by 2015 - remains virtually untapped, and it's going to send these two picks soaring...

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