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Facebook's (FB) latest earnings report caused many analysts and investors to re-evaluate their opinion of the company's prospects. Currently at $38.50 its share price is back up to the level at which it began in May 2012. Many analysts predict further upside. Is this bullish outlook warranted, or just an instinctive response to a solid financial report from a company that many predicted would struggle to monetize its operations?

A Quick Look at the Financials

Facebook reported Q2 2013 revenue at $1.8B, up from $1.1B a year earlier. Net income increased from a loss of $157M to $331M for the same period. Gross margin rose to 74% from 69% last year. The company's main revenue stream, advertising, grew from $992M in Q2 2012 to $1.6B in Q2 2013.

Advertising

As of June 30, 2013, Facebook had 1.15B monthly active users, an increase of 21% from June 30, 2012. 819M of these users are mobile and desktop users, up from 543M on June 30, 2012. 219M are mobile only users, up from 189M last year.

The company's inability to monetize its growing mobile user base drew much criticism from analysts over the past 12 months. It overcame this problem by inserting ads into users' news feeds. Mobile advertising now accounts for 41% of total ad spend at Facebook, totaling $656M during Q2 2013. It is projected to be the growth area of the business over the next 5-10 years.

While increased advertising revenue proves that Facebook is able to generate income, the company's potential for growth will depend on one thing - the effectiveness of the ads. Advertisers will not continue to spend money on ineffective promotion. Earlier this year the company announced that it had 1M active advertisers, the vast majority being small to medium business owners. If Facebook is to retain these advertisers, and attract more, its advertising model must produce results.

Effectiveness

Facebook offers advertisers two options; cost per click (CPC) and cost per thousand impressions (CPM). CPC only charges advertisers when users click on their ad. For the purpose of this discussion it is a more accurate measurement than CPM of the return on advertising spend. In the US the company's average CPC is $0.80. Globally, $0.60.

Click through rate (CTR) is the number of times an ad is clicked, divided by the number of times it is shown. It is considered the most accurate way to determine the effectiveness of an ad. Facebook's global average CTR in 2012 was 0.05%.

In short, advertisers pay an average of $80 for 100 clicks on Facebook, and to achieve 100 clicks the advert must appear 200,000 times.

Competition

How does this compare to Facebook's competitors?

Google (GOOG) is currently the market leader in online advertising. Last year Google generated $43b in online advertising revenue versus Facebook's $4b. Google's average CPC is $0.82, and its average CTR is 2%.

Yahoo! Bing recently announced its pending separation, but for the purpose of comparison its data remains relevant. The Yahoo! Bing Network is controlled by Microsoft's (MSFT) Online Services Division (OSD). The advertising revenue the division generates accounts for the vast majority of its total revenue. For 2012 Microsoft's OSD reported $2.9B in revenue. A recent study reported the Yahoo! Bing Network's average CTR in the US at 0.93%, and its average CPC at $0.85.

Comparison

To summarize, Facebook offers cheaper clicks than Google and the Yahoo! Bing Network, but users are 40 times more likely to click on a Google ad, and 20 times more likely to click on a the Yahoo! Bing Network ad. If Facebook is to maintain or grow its active advertiser base it must find a way to improve the effectiveness of its ads. The CTR of Facebook's mobile advertising is higher than that of its desktop advertising, but as things stand the majority of the company's advertising revenue is generated via its desktop site.

Alternatives

Google and the Yahoo! Bing Network are not the only competition that Facebook faces in the online advertising industry. The company also competes against a number of smaller companies that offer alternatives to traditional display advertising. A rapidly expanding area of social media advertising is social media sponsorship. Social media sponsorship is when an advertiser pays an influential individual, a celebrity or sports star for example, to publish material about products or services via their social media channels. For instance, a celebrity mom might post about a baby food manufacturer. The ad is still hosted on Facebook, but the company gets no share of the payment it generates. The payment from advertiser to publisher is processed through an external marketplace.

A study conducted by IZEA, Inc., one of the leading companies in the social media sponsorship industry, suggests that advertising in this way produces an average CTR of 10.5%. IZEA already runs a number of platforms that act as marketplaces for social media sponsorship, and the company plans to release its Native Ad Exchange (NAX) before the end of 2013. NAX is a multi-country platform that combines access to the main social media networks and brings together advertisers and influencers. Developments such as NAX make social media sponsorship one of the fastest growing areas of the online advertising industry. As it expands, advertisers will likely redirect revenue towards the results it offers.

Conclusion

All that Facebook's latest reporting confirms is the company's ability to monetize its operations. To some degree this justifies the return of its share price to its IPO level, but it is not enough to support a further rise. If the company is to compete in the online advertising industry it must improve the effectiveness of it ads. Without improved effectiveness, advertisers will migrate to Google, the Yahoo! Bing Network or alternative, emerging forms of social media advertising such as those offered by IZEA.

Source: A Major Factor Limiting Facebook's Growth Potential