Facebook recently mentioned that it is now delivering 1 billion video views per day. Going forward, videos are going to be an integral part of the Facebook experience and could bring in a notable chunk of its ad revenues. The company intends to start showing view counts similar to Youtube on certain videos that are posted by pages and public figures. This will certainly stir up interest among advertisers because video ads tend to be engaging. Youtube had 4 billion views per day in 2012, which suggests that although Facebook is far behind, it has grown significantly and has emerged as an attractive platform for video advertisers. The question is, how big can the video ad business be if monetized successfully in the context of the company’s current ad revenues? As it turns out, it is still small. However, going forward, it could become meaningful and there is certainly a high likelihood of that happening.

Our price estimate for Facebook stands at $65.50, implying a discount of about 15% to the market.

See our complete analysis for Facebook

Videos Are Still A Small Part Of Facebook’s Ad Business

At the current rate, Facebook will have roughly 365 billion video views a year. If the company starts monetizing this opportunity with pre-roll video ads, it can add $365 million in incremental revenues. Let's assume that Facebook manages to put pre-roll video ads in 20% of these video views, at an average rate of $5 per 1,000 views, which is still lower than that for Youtube. It will imply incremental revenues of roughly $365 million. Facebook’s EBITDA margin is north of 60% which implies that these revenues will result in incremental EBITDA of roughly $225 million. That’s still less than 5% of the company’s 2013 EBITDA. However, over time, the number of video views is likely to increase substantially and the company could also benefit from higher ad pricing. Unlike Youtube, Facebook has strong track record of high return on investment for advertisers. This suggests that while our estimates are on the conservative side, actual ad pricing that Facebook charges to advertisers could be much higher than that for Youtube.

Why Is Facebook Doing Well With Ads?

Facebook’s ad revenues jumped 67% in Q2 2014 over the same period a year ago. This was primarily driven by 151% increase in mobile ad sales as desktop ad revenue growth remained in single digits. Mobile now accounts for 62% of Facebook’s quarterly ad revenues, which is a big leap from the situation 1.5 years ago. So, what’s driving this unprecedented growth in advertising business on mobile?

The first reason is the increased proportion of feed-based ads. As the overall usage continues to shift from desktop to mobile, the total number of ad impressions is decreasing but average ad pricing is going up. In other words, Facebook has made the interface less cluttered but more effective for marketers, which has helped it deliver higher ROI (return on investment) to them. This, in turn, has led to a strong growth in its average ad pricing. In the second quarter of 2014, the average price per ad shot up by 123% which more than offset the impact of 25% decline in the total number of ad impressions.

The second reason behind Facebook’s success is its continuous effort to bring more advertisers onto its platform. Currently, about 30 million small business have Facebook pages. The number of active marketers stands at 1.5 million as of today, which is 50% higher than what it was a year ago. Perhaps Facebook’s greatest achievement is making its mobile ads as interesting and likeable as the regular Facebook content. This has led to higher user engagement, which is of great interest to advertisers. Some of the features such as custom audience and website custom audience have been adopted quickly by advertisers, and have enabled better targeting.

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