While most industry insiders have a firm grasp on Facebook’s monetization models, most people still don’t understand how Facebook makes money. For those that still don’t know how Facebook makes money, we thought we’d take the opportunity to break down Facebook’s various revenue streams including past and future streams of revenue. After reading this guide, you should have a complete understanding of how Facebook makes money.

Advertising Business

Facebook’s single most important revenue channel is advertising. The company has always been ad supported and most likely will always be ad supported. While some have claimed that Facebook will one day charge for access to the site, those rumors are completely false. Facebook generates over half a billion in revenue each year, the vast majority of which comes from advertising. So who is paying for advertising?

Self-Serve Facebook Advertising

The largest chunk of Facebook’s advertising revenue is the company’s self-serve advertising platform. By visiting the following page you can set up your own advertising campaign on Facebook. These advertisements are displayed in the sidebar of most pages of the site. That includes user profiles, events, groups, Facebook Pages, and third-party applications. The primary advantage of Facebook’s self-serve advertising platform is the granular targeting features.

Over the past few years Facebook has increased their targeting capabilities, including the ability to limit advertising to metropolitan areas as well as the following target variables: gender, age, network (workplace, school, etc), profile keywords, relationship status, and more. Facebook recently released the Facebook Ads API which provides large ad buyers with the ability to build robust ad managers on top of the Facebook advertising platform.

We’ve written about a number of companies who have built services on top of Facebook’s Ads API. To boil it down, the Facebook Ads API enables Facebook to reduce the amount of friction large advertisers (those who spend more than $10,000 a day) have in posting new advertisements and modify existing ones. According to numerous sources, Zynga, the developer behind the largest games on Facebook (FarmVille, Café World, etc), is the largest purchaser of Facebook’s self-serve ads.

Small businesses like doctors, lawyers, restaurants, and others are also responsible for a large amount of Facebook’s revenue generated by the self-serve advertising platform. If you want to learn more about Facebook’s self-serve advertising platform, check out some of the articles below. We expect Facebook to generate somewhere in the range of $450 million this year (2010) on self-serve ads.

• Local Advertising On Facebook Is Big Business
• The 10 Laws Of Facebook Advertising No Marketer Can Afford To Ignore
• Facebook Launches Friends Of Connections Targeting For Ads
• 5 New Features In The Upgraded Facebook Ad Manager

Engagement Ads

In addition to Facebook’s self-serve advertising product, Facebook also generates a substantial percentage of their revenue through their “Engagement Ads” product. Engagement Ads are Facebook’s solutions for large brand advertisers. Facebook places all engagement ads on the site’s homepage. Once a user logs in, they can interact with advertisements (like to one pictured to the right) which are placed on the right-hand side of the homepage.

Facebook has been ramping up their efforts to recruit brand advertisers in a number of ways but last September Facebook stepped up their efforts with the launch of Brand Lift. Brand Lift is essentially a product which enables large brand to test the effectiveness of their advertising campaigns almost immediately after their campaign is run. Facebook believes this increased level of measurement will encourage brand advertisers to spend more on Facebook Engagement Ads.

If you want to learn more about the Engagement Ads product, you can check out the articles below. We expect Facebook to generate around $250 million in brand advertising this year.

• The 4 Types Of Branded Facebook Campaigns
• Facebook Tests New Direct Offer Engagement Ads
• Brand Lift: Facebook’s Answer To The Brand Advertising Conundrum
• Live Coverage Of The Brand Lift Announcement
• New Dirty Jobs Ad Highlights The Power Of Engagement Ads
• Facebook Adds Fan Feature To Poll And Event Engagement Ads

Microsoft Banner Advertising Agreement & Search

Previously, Facebook had an advertising agreement with Microsoft for displaying large banner ads on the site. Recently, Facebook removed the advertisements internationally and it appears that they could be completely phased out of the site by the end of the first quarter this year, according to a Facebook presentation that was presented in Poland earlier this month. Facebook is phasing out the banner advertisements from Microsoft as they want to be completely self-sufficient. Total revenue generated from Microsoft advertising will be less than $50 million this year as they phase out banner ads completely.

Another less discussed agreement is the one Facebook has with Microsoft over search. When Microsoft invested $250 million in Facebook at a $15 billion valuation, part of the investment included an agreement to integrate Microsoft’s search results into Facebook. The terms of the agreement have never been public however we believe that Microsoft may be paying Facebook beyond the terms of the initial agreement. Unfortunately for estimate purposes we have to assume that this revenue is negligible although we believe it to be worth at least $150 million a year.

Virtual Goods And The Gift Shop

Facebook currently generates a large amount of revenue from the Facebook Gift shop. For those less familiar with the gift shop, it’s a product which enables users to send virtual gifts to one another. At an average cost of $1 per gift, Facebook gifts have become an extremely lucrative business, generating upwards of $100 million last year. Facebook has been slowly opening up the gift shop to third-party developers in order to increase the variety of products sold through the shop.

In August of last year, Facebook began opening the gift shop to non-profits and by September it was opened to a number of other developers. During the ongoing Haiti crisis, Causes has been offering users the opportunity to purchase gifts which directly benefit victims of the tragedy. While there are few public estimates of Facebook’s gift shop revenue, we’d expect Facebook to generate upwards of $150 million from their gift shop this year.

Facebook Credits

That last way Facebook generates revenue is through their Facebook Credits program. Initially used as a way for Facebook users to purchase virtual goods through the Facebook gift shop, Facebook is slowly opening up Credits to third-party developers. The purpose is for developers of applications, like FarmVille and other large social games, to integrate Facebook’s Credits product directly into their applications.

Facebook will in turn take a large percentage of all virtual goods sold through applications. As we wrote in our 2009 Facebook Recap, Facebook has been testing a number of ways to integrate Credits. In addition to testing out alternative payments for Credits for those users without access to credit cards, Facebook has been testing user-to-user credits as well as in-application credit integration.

Facebook is widely expected to release the Facebook Credits product for developers at this year’s f8 developer conference being held in San Francisco this April. While it will only begin rolling out later this year, we expect Facebook to generate $150 million in revenue from their Credits platform this year. This could expand up to a few hundred million in a short period of time as the volume of virtual goods sold on Facebook grows beyond $1 billion a year.

Conclusion

Facebook makes money a number of ways however advertising is the company’s revenue channel. With self-serve ads becoming a booming business for Facebook and with the growth of Engagement Ads, Facebook could be on track to generate up to $1 billion in revenue this year. While our estimate is aggressive, Facebook has been experiencing continued growth and through further education about the company’s advertising products, we’d expect Facebook to stay on track to almost double previously quoted estimates of last year’s revenue: $550 million.

While many users still wrongly think that Facebook will charge users because they aren’t able to pay for the site, the reality is that advertising is proving to be a very big business for Facebook.

Earlier this week we reached out to Facebook about the removal of skyscraper advertisements on their site. At the time, the company told us that it was bug in the U.S. and that the “problem” would soon be resolved. Today, the company has told us that all banner ads in international markets have since been removed. As a replacement, Facebook will be relying completely on the company’s internal advertisements which include social actions.

The following statement came directly from Facebook:

After talks with Microsoft, we have recently decided to stop running their banner ads on Facebook in international markets. Ad formats that feature social actions perform better and provide a better user experience since they are more consistent with the look and feel of Facebook. Facebook ads can also be targeted to people based on the information they provide. This combination of targeting and social relevance is the primary driver behind the shift in strategy.

While the company continues to serve banner advertisements in the United States, there’s no telling how long they will continue. By replacing the display advertisements, Facebook’s self-serve advertisements now have significantly more inventory. That also means CPCs and eCPMs have decreased through the company’s self-serve ad platform as Eric Eldon points out. There’s no doubt that this decrease is temporary, however international advertisers should most definitely take advantage of the current discount.

Is Microsoft disappointed with the new shift? While we haven’t spoken with the company, a dramatic decrease in inventory is always unwelcomed. Give that Microsoft has a large stake in Facebook though, any long-term increase in revenue is clearly in the investors’ best interest. Microsoft still has a great search deal with Facebook which helps the company promote Bing. While there were probably plenty of advertisers who wanted placement of banners on Facebook, they’ll now have to become more intimate with Facebook’s self-serve advertisement platform.

Alternatively, those companies can work with third party ad management solutions providers who have built services on top of the Facebook Ads API.

Facebook’s largest advertiser is Zynga, the insanely popular social gaming developer behind uber hit: FarmVille. Other application developers have also followed suit and are using Facebook’s advertising platform as a way to drive new installs. Rather than building in house advertising solutions which integrate with Facebook’s API though, many application developers are now turning to third parties with custom ad management solutions.

For example ONE Media Manager announced today that Zoosk, the popular Facebook dating application, had become their first client. We’ve also heard rumblings about other large application developers turning to some of the third-parties we previously wrote about who provide Facebook ad management software (77Agency, Alchemy, etc). While Zynga spends upwards of $72 million a year on Facebook ads according to rumors, most application developers spend a fraction of that, which means investing in an internal ad management software probably doesn’t make much sense.

If application developers made up the majority of Facebook’s ad revenue, it would be somewhat concerning as it ends up being a somewhat circular process. However large brands are spending big dollars on Facebook engagement ads and small businesses are increasing their spending on Facebook advertising. Facebook should hope that both of these revenue sources, in conjunction with new revenue models (like Facebook Credits), will eventually offset the less sustainable revenue gained through Facebook application install ad spends.

For the time being though, I’m sure Facebook doesn’t mind big developers spending millions of dollars with them!

Last July there was a mini-firestorm after a user found an ad which was using his wife’s photo in a dating advertisement. While the original story was a big miscommunication, as the ad was from a third-party ad network, Facebook does put user photos in some advertisements. Previously, users could opt-out of having their image and name used within Facebook advertisements show to their friends, however the specific privacy settings page which used to allow users to opt-out of having their information used in ads no longer exists.

Part of last year’s firestorm revolved around being able to opt-out of being displayed within advertisements. At the time, DownloadSquad published detailed instructions about how to opt out of the ads. While those settings existed under the old privacy settings, they no longer appear to exist which means users can no longer opt-out of being used in Facebook ads. While this may be an error by Facebook, it’s a pretty significant oversight considering the buzz and policy changes which resulted from the DownloadSquad article.

So what do these ads look like? I’ve posted a sample advertisement off to the right. Back in 2007, William McGeveran of Harvard Law suggested that the social advertisements were actually illegal. Since the original firestorm last year, Facebook since disabled the ability for third-party advertisers (specifically on the Facebook Platform) to display user photos within advertisements. The net result has been a decrease in application display ad click through rates.

Users now have an increased level of privacy though and there’s little chance that a user’s image will show up in a random advertisement. As for Facebook ads, users names and images can theoretically still be used and users are no longer able to opt out. While the most recent social ads don’t appear to use profile images, your name can still be used within advertisements. While having your name show up is not as shocking as seeing your profile image in a dating advertisement, users should be able to choose whether or not their name is used in an ad.

While the information may be publicly accessible (for example, you can’t hide those Pages you are a fan of), it doesn’t mean I want that information to randomly show up in an ad. Do you think it matters if Facebook uses your name in an advertisement that your friend sees? Does it make a difference if that information is already publicly accessible?

Facebook is in the midst of testing out new iterations of the site homepage, and earlier today, Om Malik posted images of the latest iteration. One of the things which immediately stood out to me was the removal of the “Log Out” button, which I’m guessing is not a frequently used link, or simply something the company would like to de-emphasize. The chat link also continues to appear in the lower right hand corner, however the site “toolbar” doesn’t take up the entire footer.

Much of the design is not exactly surprising for anybody who has been following updates to the developer roadmap as updated by Facebook. Also we noticed that there are no skyscraper advertisements on the sidebar, something we’ve heard Facebook is eliminating completely, opting to generate 100 percent of their revenue from their internal ad system. We’re not sure if this happens to be a by chance that there are no skyscraper ads or that the new design will in fact mark the removal of third-party ads on Facebook.