Why Facebook must prove the worth of social advertising

1Executive Summary

One lackluster IPO later, Facebook holds a market valuation that’s impressive but well shy of the $100 billion most expected. A large factor in that shortfall has been a concern that the company isn’t generating as much advertising revenue as it should be and that this could put a crimp in its future financial performance. Though the social network still has a number of other aspects of its business that could become revenue generators, such as virtual currency and e-commerce, it’s fair to say a huge proportion of Facebook’s theoretical value depends on its solving its ad revenue problem. Can the company show that socially driven advertising is superior to traditional ad methods? And more important, can it do so before the market loses interest?

The social network already generates a fairly substantial amount of revenue from traditional advertising: about $3 billion in 2011, according to the company’s S-1 securities filing. As large as that sounds, however, it’s less impressive when you consider the network has close to one billion users and more than 500 billion page views per month. While Facebook is one of the leaders in online display advertising – with an estimated 28 percent market share – that business doesn’t have great profit margins, especially when your clickthrough rate is as low as Facebook’s estimated .05 percent.

Beyond the display ad

Facebook’s ability to function as an advertising vehicle also took a blow just before the initial offering, when General Motors said it was pulling about $10 million worth of ad spending out of the social network after seeing lackluster results. This news seemed to reinforce some critics’ skepticism about the value of Facebook as an advertising platform, including concerns about whether they were getting enough return from their Facebook ads.

In many ways Facebook is suffering from the same kind of malaise that many media companies experience when it comes to advertising. The standard display ad banner in general is simply not producing enough revenue to keep most companies in the black, since the cost of such ads is driven by the amount of inventory. After all, there’s no shortage of web pages for advertisers to put their banners on, and so the price continues to drop. While Facebook can make billions from such ads simply because of its sheer size, that isn’t going to produce enough growth to justify a $100 billion market value.

There are some things Facebook can do to improve this performance, including a move it is expected to roll out soon: The social network will offer ads that are targeted based on the behavior of Facebook users when they are on third-party websites. According to several reports about the plan, the company will offer a Google-style real-time auction platform for ads on its site, and the targeting of those ads will use data collected from external websites. How Facebook handles the privacy implications of this kind of targeting remains to be seen, but at least this strategy would be able to offer some extra value to advertisers beyond a traditional banner.

Proving the worth of social elements

But Facebook’s ultimate goal in advertising is to show that the social elements of the network are worth paying more for. In an attempt to do so, the company has taken some steps to add new forms of advertising that are driven by social features, including what it calls “sponsored stories,” which use comments made by Facebook members as a component of an ad. But there are problems with this approach, too, including the obvious fact that some users don’t like having their comments or status updates used in this way. Facebook has even been the target of a lawsuit in California that alleges this kind of behavior is against the law.

That kind of problem reinforces something Sir Martin Sorrell, the chief executive of global advertising and marketing giant WPP Group, said about Facebook and its effectiveness as an advertising platform. Although WPP has experimented with a number of campaigns, Sorrell said he wasn’t completely convinced the social network can function as an effective ad environment. The primary goal of users is to socialize with one another, and advertising or marketing messages are seen by many as an intrusion. Google ads are often seen as helpful for those who are searching for something, but Facebook ads can simply seem irritating, like someone handing coupons around while users are chatting with one another over a beer. Said Sorrell:

The point is that Facebook is a social medium, not an advertising one, like search or display . . . You interrupt social conversations with commercial messages at your peril.

Facebook took its first real shot at proving that its ads have more to offer than run-of-the-mill display ads with a report from comScore that looked at the effectiveness of Facebook’s socially powered ad features, including sponsored stories. The study found that users who were exposed to some form of social ad involving Starbucks were almost 40 percent more likely to buy something at a Starbucks in the four weeks following that exposure. Better still for Facebook, the report said a similar effect was also seen on friends of those users. Theoretically, at least, that suggests the network effects of the social platform extend to advertising.

There’s another part of the report that Facebook is probably pretty happy with: According to the study, there was a “statistically significant” increase in both online and in-store purchasing behavior after exposure to Facebook ads, even if users didn’t click on them. This could help Facebook make the case that its advertising is effective even if its clickthrough rate is dismally low. Whether advertisers buy this argument or not remains to be seen.

What Facebook should do

Here are a few things Facebook needs to do in order to prove social advertising has enough value for advertisers to put more of their spending toward it.

Provide some hard data. The comScore study goes part of the way toward justifying increased spending by advertisers, but plenty of critics have said Facebook likely fiddled with the numbers. The company needs to produce objectively verified numbers that advertisers will take note of without questions.

Join an advertising body. One of the ways to get those numbers is to become a member of an advertising body like the Internet Advertising Board (IAB), which provides a kind of stamp of approval that could further reduce skepticism.

Focus on real numbers. Facebook likes to talk about having more than half a billion daily active users (DAU), but this number includes those who interact with Facebook widgets on third-party sites. Advertisers want to know who is seeing their ad on Facebook. And obviously this number should be growing as well.

Prove that targeting works. One of the things advertisers are most interested in about platforms like Facebook is that they can hypertarget offerings to specific demographics or locations. However, they need proof that this improves ROI, so Facebook needs to connect that targeting to behavior, like sales of actual products or services.

Facebook’s big challenge going forward is to prove that social advertising is so effective it is deserving of the lion’s share of digital ad spending. The comScore study will provide some much-needed ammunition, but since Facebook sponsored the research, skeptics may remain unconvinced. Probably the biggest factor working in the social network’s favor is the fact that the advertising industry knows run-of-the-mill display ads aren’t working, on Facebook or anywhere else. In other words, advertisers know they need to take advantage of social effects in order to reach new markets, and Facebook is currently one of their best chances of making that happen.

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