Facebook: How Compounding Has Worked

Simplified explanation of the social network's advertising revenue model

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Sep 18, 2017
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I visited the Bay Area last month and met some friends from Google (GOOGL, Financial), LinkedIn, Facebook (FB, Financial) and some other tech companies. During one conversation, the topic of how Facebook grew its ad revenue so fast came up. A friend from Google, who works on ad revenue there, mentioned he saw first-hand how Facebook was taking share in the digital ad world, yet missed the stock completely. He also explained to me how Facebook’s ad revenue works, which I found extremely interesting and would like to share here so we all have a better understanding of how Facebook and, in general, social networks’ advertising revenue model works.

The general formula for digital advertising is very simple: ad revenue= price x volume. Price is generally expressed as CPM (cost or price per thousand impressions) and volume is expressed as impressions.

CPM is very straightforward, driven by market factors. Impressions are very complex compared to CPM as there are a number of factors that drive impressions. Specifically to Facebook, the general formula for impressions can be simplified as the following:

Impressions (per day) = DAU (daily active users) x minutes per user per day x scroll rate x ad load.

DAU and minutes per user per day are fairly self-explanatory. Scroll rate is the number of posts an average user views per minute and ad load is a relatively opaque measure. An ad load of 1% means one ad for every 100 posts. An ad load of 5% means one ad for every 20 posts.

Facebook only discloses the actual DAU growth rate, total Impressions, minutes per user per day and CPM.

Let’s use 2015’s ad revenue to see how it works:

At the end of 2015, Facebook had 1.037 billion global daily active users and, on average, a DAU spent about 41 minutes per day on Facebook’s platforms. On an annualized basis, this gets us to roughly 15 billion user minutes per year. From what I gathered and estimated, in 2015 a DAU viewed about eight posts per minutes and Facebook’s ad load is somewhere around 7% to 7.5%. Therefore, 15 billion minutes times 8 times 7.5% equals 9 billion impressions. CPM for Facebook is about $1.80 to $1.90, so let’s call it $1.85. Now we can calculate the company’s ad revenue using our formula CMP x impressions, or 9 billion x $1.85, which equals $16.65 billion. Facebook’s actual ad revenue for 2015 is $17.08 billion. Since not all measures are disclosed, some estimates are required and some information is very hard to find (second-level information).

We can see why Facebook’s model has been so powerful – it benefited from the compounding power of almost all the drivers (except for scroll rate, which had an engineered change but I will not go into the details). DAU, CPM, minutes per DAU per day and ad loads were all increasing at a rapid rate. It has truly been a lollapalooza effect.

Going forward, whether Facebook can maintain the compounding power of the ad revenue drivers and how fast those drivers can compound are the billion-dollar questions. At this point, I do not know enough to have an opinion. But with an understanding of how Facebook makes money, I can at least see how the compounding works.