There are 277 million users on LinkedIn (NYSE:LNKD), and a similar number for Twitter (NYSE:TWTR). There's 1.2 billion on Facebook (Nasdaq:FB), give or take. Then we have 540 million people on Google+ (mostly people who haven’t yet figured out how to delete their profiles while keeping their Gmail accounts intact). Even MySpace manages to retain about 36 million users. Such volume is the short answer to the question “How can these companies make money?”, given that they more or less give away their products. But it still doesn’t explain where the revenue comes from: After all, 248 million Twitter users times zero is zero.

This isn’t a unique observation, but it’s a crucial one: If you’re not paying for the product, the product is you. The real transaction here isn’t you receiving enjoyment in the form of a free temporary distraction created by a media company at great expense, but rather, that media company renting your eyeballs to its advertisers. For many people, that truth manifests itself most clearly in television. CBS (NYSE:CBS) doesn’t come up with a new episode of "NCIS" every week strictly to please you, the demanding viewer with a limitless capacity for being passively entertained. It’s because you and 18 million other people will watch that episode, and thus pay at least subconscious attention to the 16 minutes of commercials that are interspersed throughout it. For a car manufacturer or fast-food restaurant, there are few more efficient ways to grab customers’ attention, something CBS and its rival networks are well aware of. Media companies are interested in pleasing the brewer before the viewer.

For social media, this goes double, if not quadruple. There’s a reason why Facebook’s 10-K filing with the U. S. Securities and Exchange Commission (SEC) uses the acronym ARPU, as in average revenue per user. Your account contributed $5.32 to Facebook last year. Congratulations, you’ve been commoditized and you never even knew it. Multiply that by the aforementioned estimated user base, and now you can understand why Facebook stock trades at 110 times earnings and has a market capitalization 10 times the size of its asset holdings. The company’s stock price has doubled since its initial public offering of two years ago, which some people thought even then was unjustifiably high.

When Facebook founder Mark Zuckerberg went looking for a chief operating officer in 2007, it’s no coincidence that he selected not an engineer nor a technologist but a vice president with a background in advertising sales. Sheryl Sandberg had spent 6.5 years selling advertising as a vice president at Google (Nasdaq:GOOG). Growing Facebook’s user base to the point where it reached critical mass was obviously important to the company’s operations, but only to the extent that it provided something to attract advertisers. To an uninterested observer, committing the equivalent of the gross domestic product of Honduras to a texting application might sound like the height of dotcom era hubris and recklessness. But it isn’t. WhatsApp boasts 400 million users, which to Facebook management means an even greater stock of susceptible minds to sell as a unit to companies looking to, for instance, move a few more mobile phones this quarter. Every acquisition Facebook has made since, whether it was $1 billion for Instagram or $19 billion for WhatsApp, was conducted with the same goal in mind.

Advertising isn’t just a way for Facebook and its ilk to perhaps earn a little bit of revenue in between hosting family photos and personal musings. It’s the very purpose of the site’s existence, and the same goes for Twitter and LinkedIn (NYSE:LNKD). Twitter’s status as a place to find instant, unfiltered, democratized updates on everything from celebrity arrests to international civil unrest might make it important to the modern exchange of ideas, but again, that’s secondary to keeping the advertisers happy. Take Twitter’s word for it, directly from its own recent SEC filing. The company’s forward-looking statements concern:

"Our ability to attract advertisers to our platform and increase the amount that advertisers spend with us."

and

"Our ability to improve user monetization, including advertising revenue per timeline view."

The Bottom Line

From the consumer’s perspective, advertising was originally a way to enjoy a finished product at a notably reduced cost. Without inserts and placements, the news stand and subscription prices of magazines and newspapers would have to be a multiple of what they are now. In fact, such publications would be not economically viable at all – the rise in price would necessarily reduce the quantity sold to practically zero. The same applies to broadcast television, and most of all to social media sites. In theory, Facebook could just charge that $5.32 average revenue per user directly to the user, on a subscription basis. The problem is that not only would users either cancel their accounts by the millions, or never agree to pay the subscription fee in the first place, setting a fee would also eliminate the possibility of further dynamism and growth. For a social media site to go from 300 million users to 600 million and beyond, access has to be easy, almost effortless, and most of all, free. Using an advertiser-supported model, rather than charging each user individually, is unquestionably the easiest way for Facebook to garner as many users as possible. The more users on the site, the greater the number of advertisers willing to engage them, and the more those advertisers are willing to spend. Making for the most virtuous of circles for Facebook’s management and shareholders.

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