How Facebook Reaches $20 Billion in Revenue

How Facebook Reaches $20 Billion in Revenue
A Payments System and Social Ad Network Will Take It to a $100 Billion Valuation

Facebook, at over 500 million users, has transformed the web, and indeed the planet, by connecting us all in ways we weren't before. At their current growth rates, they will finish this year at around 600 million users and will be larger than Google by the end of next year (if they aren't already, see here). (As Facebook's head of growth once told me, the nice thing about growth being truly viral is that it becomes very easy to predict your future growth. Facebook actually employs several epidemiologists to measure and predict growth.) Once Facebook has a true web-wide view (i.e., is connected with nearly all 1.1 billion people on the web), their scale becomes completely un-ignorable by all major advertisers. They are already at this point today in many markets, but this will become true next year in essentially all online geographic markets.

Today, we understand that Facebook generates about $2 to $3 per user per year in revenues. Google, however, generates about $25 per user per year (more than $25 billion in revenue from about 1 billion users). The gap is considerable, but Facebook is just getting started with their monetization efforts. Their main forms of revenue today are engagement ads and self-service ads. The non-self-service ads are sold by a large and competent sales staff around the world that caters to brands and agencies. They are selling these ads largely on a CPM basis. That is, they are not positioned as performance-oriented ads, but sold more like TV. Reach and frequency are the main measurements and selling points. Self-service ads are sold more to the mid-tail of advertisers and are sold more like Google AdWords on a CPC basis. These ads allow for extremely rudimentary targeting. The targeting criteria is based on the info you, the user, have put in about yourself. I am a male in my early 40s in New York City and I like tennis. So, I see ads targeted at these keywords.

There are pros and cons to these forms of advertising. First, Facebook's reach is undeniable and advertisers love the idea of appearing on everyone's Facebook page for an entire day. The CPM ads are targeted more at brand advertisers that are less interested in demand fulfillment and more in awareness generation and demand creation. As Sheryl Sandberg has pointed out many times, this "brand advertising" market is many times larger than search/display "performance" marketing. They have their eyes set on TV.

I think the main reason they are focused on this is because, quite frankly, ads on Facebook don't perform very well. We know that the effective CPM of these ads on Facebook is well under $1. Advertisers understand that social media has proven, thus far, to be a place where people don't seem to want to be interrupted to click an ad. In addition, the performance of rudimentary ad targeting doesn't nearly beat the efficacy of search targeting or good display behavioral targeting for that matter. That makes it less attractive to advertisers who measure performance by clicks, and also to a company who expects to be paid per click. Hence, sell CPMs! Facebook has lots of growth in these two ad strategies. But that is not what will get them to $20 billion in revenue quickly.

What will? Two things: payments and off-site social targeting.

Facebook payments, with Facebook getting 30% of all virtual good sales, will generate several billion dollars a year once it is ramped. This can become a $4 billion revenue line for Facebook within three years. But the other often under-discussed opportunity is an off-site socially targeted ad network.

We know from our investment in Media6Degrees that the most effective form of ad targeting after search is social targeting. These are ads that are targeted essentially at the friends of a brand's existing customers. Your customer's friends show extremely similar brand affinities as you. Of course, these prospects don't have to be the actual friends of your customers...they just have to have similar social signatures to your customers. And Media6Degrees is the leading company pioneering this form of targeting. Other companies exist trying to do the very same thing. Frankly, the results are staggeringly good.

The issue for Facebook is that applying this advanced form of targeting on their site would be uninteresting, owing to the lack of performance of advertising on social media. This is where Facebook Connect comes in.

Already, more than 2 million sites have implemented Facebook Connect. I believe what Facebook will do is to offer to every one of those sites essentially an AdSense replacement. Pull out your AdSense ads and replace them with socially-targeted Facebook ads. When a friend of a brand's existing customer appears on a publisher's site, they can see ads for that brand. I believe these results will perform considerably better than AdSense's contextual/semantic targeting and hence provide publishers with larger payouts than Google provides them. Facebook already has the large social data set to understand the connections necessary for this targeting. Of course, this will further encourage more sites to implement Facebook Connect and Like buttons, since Facebook can make these requirements to be in the social targeting ad network.

By the way, this form of targeting is proving to work equally well for video. Video is likely to be the most important form of ad creative deployed for brand advertisers. But to whom do you show the commercials? The friends of your existing customers.

At scale, with, say, 5 million sites in this network, Facebook could operate the largest off-site ad network (display and video) that outperforms all others. At this scale, I can see this generating $15 billion a year in revenue.

What's stopping them today from doing this? Well, first, they don't have to. They have plenty of headroom left in growing the existing businesses. In addition, the data science necessary to pull this off at scale is profoundly challenging. It's not as easy as it sounds, particularly if performance matters -- there is a cost to showing an ad to someone who may be connected to a customer, but not close enough. It takes years to perfect this form of targeting. Finally, the current privacy scrum needs to further settle out. I think we could see Facebook launch products like this in the second half of next year. This will get them to $20 billion in revenue and worth at least $100 billion in market cap. Stay tuned.