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How does Facebook make money?

Facebook’s figures are quite astonishing. The site’s initial public offering (IPO) was priced at $38 a share, giving the site a $104billion (£66billion) valuation and making it the third-largest offering in US history.

That rated Facebook as bigger than Amazon (£62billion), Cisco (£57billion) but behind Google (£129billion) and Apple (£315billion).

Not bad for a site that’s only eight years old and was set up by students in a Harvard dorm. It now has 900 million active users and if Facebook were a country, it would be the third largest in the world (after China and India).

Facebook claims it had an average of 526 million daily active users in March 2012, an increase of 41% from a year ago. It had registered 125 billion "friend connections" as of 31 March and 3.2 billion "likes" and comments.

Independent figures show people looked at more pages and spent more time on Facebook last month than on any other site in the world (including Google).

[Related link: The latest Facebook share price, information and headlines]

Show me the money

That’s all well and good, but how does Facebook make money and why are investors piling their cash into the site so sure it will continue to rake it in?

In short, advertising. The site made $3.7billion (£2.4billion) of revenue last year, up 88% on 2010, with $3.1billion (£2billion) coming from advertising. The rest comes from payments and other fees which have been making up a large percentage of Facebook’s revenue over the past two years.

Advertisers are attracted by two key things on Facebook; firstly, its massive reach with around 500 million daily active users, and secondly the ability to target ads with “relevance” based on the information individuals share with the website.

It’s all about you

If your interests and status updates talk about tennis expect to see lots of tennis-related ads popping up on your profile page. And if a woman changes her relationship status to “engaged”, she’ll suddenly see a lot of adverts for wedding dress shops in her area popping up.

Basically, the wealth of information Facebook stored on each of its users makes it an advertiser’s dream.

Another thing Facebook ad can do is highlight users’ friends’ connections with a business or brand. So if your friends are in the habit of “checking in” at certain stores or places, you’ll know about it and perhaps be influenced to shop there too.

Phone lines down

One area where Facebook hasn’t exploited money-making opportunities yet is advertising on mobile apps. More than half the site’s  845 million monthly active users access the site via mobile phone yet neither Facebook apps or the Facebook’s mobile website have adverts.

Zuckerberg is aware this needs to be addressed. In a document companies are required to submit prior to floatation which lists the major weakness of their business, Facebook acknowledged that future growth could be harmed if the site is "unable to successfully implement monetization strategies for our mobile users".

However, Facebook’s recent purchase of photo-sharing app Instagram  for $1billion (£636million) could provide Facebook with a route into the mobile world as well as keeping the app out of the hands of rivals such as Twitter or Google.

Beyond ads

Non-advertising revenue on Facebook comes from payments for games on the site, mostly for games made by Zynga. The social network game development company is responsible for games such as CityVille, FarmVille, Empires & Allies and ZyngaPoker.

One of the most popular Facebook games FarmVille allows users to harvest a virtual farm by planting and growing crops and trees, and buying livestock. Gamers are given virtual coins to set up their farm and they earn more from matured crops. But gamers who are eager to progress through the game can buy extra virtual coins with real money.

Facebook takes a 30% cut of Zynga's revenue, and a roughly similar cut from other companies. Virtual goods accounted for 12% of Facebook's revenue for 2011, according to documents filed by the company with the Securities and Exchange Commission.

With Facebook users happy to spend $445million (£283million) on goods that only exist virtually, it’s easy to see why investors ploughing money into Facebook this week might expect it to be a one-way bet.

Facebook has already said it “may seek to extend the use of payments to other types of apps in the future” - but how well this will go down with Facebook users who are used to the site being completely free is anyone’s guess.

Ads undermined

The continuation of impressive advertising revenue is in doubt too. General Motors has already announced plans to pull its £10million advertising from Facebook as it wasn’t converting enough sales.

According to WordStream, a provider of search engine marketing software and services, Google ads get 0.4% click-through rate, but Facebook gets just a poor 0.05%.

In other words, Google's ads are almost 10 times more effective than Facebook's ads. And you can see why; people use Google as a search engine while they log on to Facebook to see what their friends are up to.

Finally, you only have to look at the history of tech stocks, such as Friends Reunited and MySpace, to see ventures with promising starts not reaching their apparent potential.

So, after launching on to the stock market with great fanfare, time will tell whether investors will “like” Facebook.

[Related feature: Should you buy Facebook shares?]

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