Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

How Does Facebook Generate Its Revenues?

|Includes: Facebook (FB)

Facebook is the cigarette manufacturer of the digital era.

What about cigarettes made for such successful stocks?

They sell for dollars, cost cents to make, and are addictive too!

We all want to make money being invested in great companies. But how often do we really know what they are doing? What their special sauce is?

Let's rewind and try bed ourselves back in earlier times. Back before there were ads on Facebook.

It was MySpace's cooler, more handsome, older brother. But underneath the social, all your college friends are on it, hook, the business was still a website, and the stock had limited prospects.

When they introduced adverts, they did what everyone did and put display ads around the page. At this point in time, Facebook was simply AOL: A walled garden where they served you banner ads. As Yahoo has shown, banner ads do not make for a good stock investment.

If there is one reason Facebook might, and this is still unproven, might be a better investment than Google, it is mobile.

The iPhone happens, Android happens, and more and more people start using Facebook and Google on their smartphone.

Google is obliged to show you less adverts on a smaller screen. Otherwise it puts people off.

Facebook was obliged to leave out display ads and put adverts directly into your newsfeed. This turned out to be the best thing that could have ever happened to them.

At first Zuckerberg et al were incredibly scared about putting off users, but after much testing they discovered people just sucked up the ads. They are yet to find the level that stops users scrolling down their newsfeed. They are yet to find a level where they stop making more money from their users.

Facebook ran a test, where they disabled people's smartphone app, to see how long before people stopped opening the thing.

Never. People didn't stop. They might log in through the browser as well. But they kept trying the app.

Facebook's business model is your time. They are churning you and your friend's content back at you. And lacing it with advertising they make money on.

Some will dislike my comparison with cigarette stocks.

Firstly, remember the fact that cigarettes can kill you is a side effect, if the cigarette companies could have separated that out they would have. It was most definitely not part of their business model and if anything, the biggest let down of this industry was it did not figure out a way to stop cigarettes killing you.

Killing the customer is a terrible investment characteristic.

Secondly, Facebook have hired many of the cleverest artificial intelligence specialists on the planet. They are investing in cutting edge machine learning. Most of their time is spent writing AI that figures out how to make your newsfeed more addictive.

Think endless scroll. Think leaving out friends you consider dull. Think identifying friends you have a crush on.

As this is seeking Alpha it is oligatory to touch on both financials and valuation. Facebook have 84% gross margins and 20% operating margins.

Facebook is trading at 63x Fy15e eps and 32x Fy17e. It is EXPENSIVE. One point I would make here, which illustrates why addiction is so important, is if the revenues and gross margins are sustainable, the stock is cheap. This is because the operating expenditures are highly discretionary.

Although Google and new tech has rejected high margins, if you think about it, why can't they have the same c50% operating margins like Microsoft's Windows business or Checkpoint?

Operating costs are largely Facebooks decision. And if you double the margins, on stable revenues, you halve the multipe.

Addiction on Facebook

The good news in this is Facebook doesn't want to compromise your privacy. They want to use your private thoughts to scroll more!

When Facebook invests in Instagram, Whatsapp or Occulus Rift, they are trying to identify how you are going to spend your time going forward. They are pretty good at this too, even if the money they pay is eye watering.

Google is at its heart finding out what you're going to buy. Amazon is a platform for you to buy things. Facebook is selling you addiction.

Enjoy insights like these? Want to know why AirBnB is clearly not part of the sharing economy? Then check out this website. It is all about insights into how companies make money.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.