Facebook's $100 Billion Valuation Could Be Cheap If This Change Happens

In order to assess how social media platforms can make money, I highlight advertising, gaming, commerce and apps. With advertising likely to be the biggest contributor to the revenues of social media platforms, I illustrate the nature of hypertargeted advertising, and argue that this means social media -- particularly Facebook (FB) -- could take a much bigger share of total adspend over the next five years. I forecast that social media advertising could reach $38bn by 2017, commanding a 6% share of total advertising spend.

The reality is that social media remains very much in the early stages from a monetisation standpoint. I believe that most social media platforms are, for now, primarily focused on building a large, engaged use-i.e., they are in land grab mode. In fact, Facebook in its S-1 file described that "most advertisers are still learning with the best ways to leverage Facebook to create more valuable ads".

Why? Although barriers to entry are low and switching costs moderate, I believe there are benefits from scale and positive network effects. First, as Metcalfe's law states, the value of a network grows in proportion to the number of connected users. The classic example is the telephone system: if there was only one user of a telephone system, the network is largely useless. However, as the number of users rise, the value of the network similarly grows and becomes self-reinforcing.

Second, for social networks specifically, a larger user base drives other benefits including more user data, which can be utilized to increase engagement. Additionally, in the case of social networks with APIs, a larger user base attracts more third-party developers to create applications, which can also grow engagement and generate more user data. Lots of users and high engagement create opportunities to produce revenues.

Greater revenues, in turn, allow the platform to invest more in new features which can enhance the number of users, the utility of the network, and engagement. All of this creates a virtuous cycle.

The change of print ads to online ads is a major shift that should bring huge investment opportunities and potential winners that currently appear "overvalued." According to FBstocksecrets, one recommended guide for investors interested in this trend, there are 6 Companies that could be the winners and one of them is Facebook. As this website explains, Facebook could see its value doubled if online advertising gets 8% of the whole advertising spent.

To better understand and assess the business opportunity I can draw an analogy with Microsoft's (MSFT) Windows business model. In the traditional PC environment, Microsoft's Windows operating system was the underlying, foundational platform. This platform allowed Microsoft to develop first party applications (such as Office), while other software providers created third party applications. In this case, Microsoft generates revenues from the sale of the OS and first party apps, but not from third party apps.

In contrast, social networks are free to users as are most first party applications, such as the photo, messaging, and groups applications on Facebook, which are core to the platform. But social networks can generate revenues from ancillary streams like advertising. In addition, some platforms such as Facebook can share in revenues with certain third-party application providers

Ultimately, I believe that social media platforms with scale will have multiple opportunities for monetization in a number of categories:

1. Social Gaming one of the first successful categories on social media platforms. Casual gaming is ideal for social media platforms because they can enhance virality and drive user engagement. Social media platforms will monetise this by taking a fee for distribution.

In addition, it can be an opportunity to enable payments and virtual goods. Over 53% of Facebook users play games on the platform. Zynga (ZNGA) is a big winner from this trend, with revenue up 59% YoY to $311.2M. A big part of this comes from Facebook.

2. Commerce on social media platforms will emerge as companies begin to leverage the social graph, i.e., the network of individual relationships between users of the platform. Product recommendations and the opportunity to create a one-to-one dialogue with users who have expressed a 'like' for a brand could help drive conversions. Over time, companies will increasingly sell their products and services directly through the platform. For example, Warner Bros., earlier in 2011, made Batman: The Dark Knight available for streaming on an electronic rental basis via Facebook. Amazon (AMZN) could profit from this shift because it could better understand how different consumer trends emerge and help the site better predict which products to sell. Jeff Bezos explained in a recent conference that social is a big part of Amazon future because it will be essential to maximize user experience. FBstocksecrets explains this trend very well in the chapter 'social ecommerce'.

3. Payments will become a core element of the revenue generation of social media platforms as social commerce and gaming expand on the platform. Facebook has already built a "Credits" system where 10 Facebook credits equate to $1 and these credits can be used to purchase digital goods. For each transaction with Facebook Credits, the platform receives 30%. I note that PayPal and most major credit cards are accepted funding sources for Facebook Credits.

4. Advertising is already a major source of revenue for most social media companies. A large member base combined with user data provides the opportunity for sophisticated targeting. Advertisers can target based on specific interests (explicit graph), inferred interests (implicit graph), and by geography, gender, age and other demographic information. Facebook, as one example, offers "Sponsored Stories," a form of advertising that highlights the activity of a user's friends who interacted with a brand. Twitter also offers Promoted Accounts and Promoted Tweets offerings.

5. Location services could facilitate local offers from social media players. Platforms like Foursquare are paving the way for fully integrated social platforms delivering offers, discounts, and recommendations from the social graph. This plays to one of social media's strengths, which is its strong link to mobile/smart phone usage.

6. Specialized applications and services will also likely emerge that are unique to the characteristics of a platform. A primary example of this revenue opportunity is LinkedIn (LNKD), which is targeting a subscription model for users but also an Enterprise opportunity for job postings, resume submission, and acquiring talent for enterprises.