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Facebook: To Buy or Not To Buy?

Steven is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Now that the cat is out of the bag and Facebook (NASDAQ: FB) has gone public, more questions than answers have asserted themselves.  Mainly, is Facebook’s business model rock solid for investment?  In this commentary, we will cut through the noise and get right down to business to determine if Facebook is indeed a great business to get involved with. 

Dollars Per User              

Taken directly from Facebook’s Key Facts page, as of March 2012, the social media juggernaut boasts 901 million monthly active users.  From that number, 526 million use Facebook’s services daily and 488 million use their mobile offerings.  Given that Facebook was valued at $100 billion during its IPO debut, each user was worth $110.99 towards its valuation.  This is especially high when you consider how little revenue Facebook is generating off their enormous user base.

For full year 2011, Facebook earned $3.7 billion in revenue, breaking down to $4.63 per September 2011 total active user (800 million).  When using the March 2012 user base, this figure drops to $4.11.  In other words, Facebook could not figure out a way to make more than $5 per user in 2011 and this justified a $100 billion IPO valuation.  Wait, what? 

For full year 2012 estimates, analysts expect Facebook to grow revenues 34% to $5 billion, yet the path to continued growth remains unclear. 

Usage Trends

Facebook admits more users are shifting (“substituting” as they call it) away from web to mobile, potentially threatening their business model, should they prove unsuccessful in monetizing their mobile products.  This trend is problematic because Facebook does not generate a meaningful amount of revenue from these offerings.  The reason is simple: there are fewer opportunities to deliver ads without harming the mobile user experience.  To top it off, its daily active user count is rising faster than the number of ads delivered, signifying even lower revenue per user.

To combat this threat, Facebook has been experimenting with its mobile strategy by embedding ads within its highly addictive newsfeed, but the results have yet to bear fruit.  Whether or not this approach will substitute web revenues remains to be seen.  The challenge becomes how far they can push it without making the newsfeed less captivating.    

Irrelevant Ads

Pudding experts say the proof comes from within, and judging by General Motors’s (NYSE: GM) recent decision to pull their $10MM ad campaign on Facebook, the pudding is, well, disappointing.  That’s because Facebook’s advertising effectiveness is nearly half the industry standard.  According to WordStream, it is estimated that Facebook advertisements have an average click through rate of 0.051%, where the industry standard is 0.1%.  As a frame of reference, Google’s (NASDAQ: GOOG) average click through rate is 0.4%, meaning Google is 6.8 times more effective at getting users to click on ads than Facebook. 

Association Issues

As evidenced by click through rates, Facebook is proving to not be an online destination for shoppers; users are simply not in shopping mode when they log onto Facebook.  When people want to buy or research a product, they are more likely to use internet search engines like Google.  This helps explain why Google’s conversion rate is 3x higher than the industry average because they know what the user is looking for, and in turn, can deliver a more effective ad campaign. 

Unless Facebook decides to get into the search engine business, or, figures out a way to get people to use their products for shopping (which will make their ads more relevant), this collective mindset will likely remain a major issue to their business model over the long term.  Changing people’s opinions on products or services and how they are used is a difficult challenge and will take serious innovation on Facebook’s behalf.  To put matters into perspective, think about how much trouble Google is having getting the populous to associate their brand with social networking.         

Final Thought

Without question, Facebook’s most valuable asset is the household name they have made for themselves and I don’t see that changing anytime soon.  Unless Facebook starts charging for its service, long term revenue growth will remain focused on delivering more advertisements in a more effective manner.  In my mind, Facebook has three major options to consider outside of acquisitions: deliver more effective ads, monetize mobile, or pioneer new approaches.  If any of these options are adopted too aggressively, each has the potential to negatively affect user experience, potentially damaging their household brand.  While seeking growth, Facebook must act in a delicate manner to ensure any changes to its experience feels gradual.       

Although I think of Facebook as an incredible social platform, I don’t think of it as a gold mine for advertisers, and that’s okay with me.  Speaking to the business side of things, you won’t find me buying shares anytime soon.  

TopDownTrends has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and Google. Motley Fool newsletter services recommend General Motors Company and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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