Social Networking: Investing Essentials

Here's the back story on one of the newest and hottest industries investors can put their money in.

Daniel Sparks
Daniel Sparks
Jul 31, 2014 at 9:29AM
Technology and Telecom

In 1990 "social networking" was something you did at a business cocktail party. Today, however, there are plenty of social networks on the internet, and even social-networking stocks. What's more, these stocks boast some impressive market capitalizations. Most surprisingly of all, and contrary to what we may have thought even as late as 2010, these social networks are capable of bringing in some incredible amounts of cash.

Modern technology has introduced new ways of socializing and interacting that we would have had a tough time imagining several decades ago. Advertisers, of course, want in on it -- and they're getting their way. Image source: Facebook.

What is the social networking industry?

A social network is simply an online community that provides a medium for some sort of social interaction. The most important feature of a social network is that it becomes stronger with every additional user who joins the platform -- a concept known as the network effect. Today, Facebook is among the best examples.

Another key feature in the social networking business model is that it's a platform. Once the platform is up and running, it doesn't have the same expensive maintenance costs or cost of goods that more capital-intensive industries such as transportation and consumer electronics have.

How big is the social networking industry?

The industry currently stands at about $9 billion in revenue worldwide, according to industry research company IBISWorld. This figure, however, is growing at an incredibly fast pace -- largely thanks to Facebook. Between 2009 and 2014, the industry grew at an average annual rate of 36.1%, according to IBISWorld. In 2014, Facebook, LinkedIn, and Twitter essentially contributed the majority of this revenue. But considering how rapidly the industry is growing, it wouldn't be surprising to see a new entrant in the coming years quickly gain ground on the current market leaders.

How does the social networking industry work?

The industry makes most of its money from digital advertising, pitching advertisers on their networks' detailed knowledge of user activity and information, which can be used for highly targeted marketing.

Other common ways social networks make money is through payment infrastructure that enables users to buy digital and virtual goods (social games are among the most frequently purchased virtual goods) from within the social platform. 

What are the drivers of the social networking industry?

There are two main drivers to the social networking industry.

The first is the trend of increasingly affordable personal computing devices, combined with soaring availability of high-speed wireless Internet. This trend has turned computing devices into better tools for communication than ever before. Instant communication across geographies is simply easier than ever. Capitalizing on the opportunity, developers have built networks and platforms to organize communication -- and glean user information for advertisers while they're at it.

While technological advancements that make personal computing devices ubiquitous, more capable, and connected will continue to play an important role in the growing industry of social networking, especially in emerging and developing countries, it's the recent shift toward mobile connected devices that's catapulting the industry.

Consider, for instance, Facebook's history. While the number of its total monthly active users between the second quarter of 2012 and the second quarter of 2014 grew by 38%, the social network's number of mobile monthly active users grew 97%. This has had an enormous impact on Facebook's business, pushing mobile ad revenue from 0% just over a year and a half ago to 62% of Facebook's revenue in the second quarter of 2014.

The shift to mobile has had a dramatic effect on the entire social networking industry. Not only has it introduced more effective ways to use social networks, but the ad products on mobile are also turning out to be more engaging and more effective than those on desktop. The shift to mobile, therefore, has been a huge catalyst for social networking industry growth.

Going forward, social networks are increasingly looking to emerging markets and developing countries to provide further growth opportunity for the industry. The same two drivers that sparked a surge in social networking in developed countries (affordable PC's and the expansion of mobile technology) are likely to begin playing out in the rest of the world, too.