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Inside Facebook’s Money Machine

There’s been a lot of talk about Facebook’s valuation, but the real question behind that valuation, is how Facebook makes money and what its prospects are in the future.

Facebook
AP
Facebook

First: The value of Facebook’s reach shouldn’t be underestimated. Facebook had 901 million monthly active users at the end of the first quarter — and it turns those users into dollars, primarily by showing them ads.

It had 526 million daily active users at the end of the first quarter, 41 percent more than the prior year. Users generated an average of 3.2 billion likes and comments per day in the first quarter, and there are more than 125 billion friend connections.

One key number: mobile is a huge driver of growth — the company now has about 500 million monthly average users. That’s a potential source of revenue growth, but also a challenge.

The company only recently started running ads on its mobile platform, but it doesn’t put as many ads on the mobile experience as it does on its website. Since mobile usage is growing faster than its overall usage, that means Facebook’s ad revenue can’t really grow as fast as its usage.

Nuts and bolts: Facebook generated $3.7 billion in revenue in 2011, up 88 percent from the prior year. While that growth is still impressive, it’s worth noting that revenue growth is slowing — revenue grew 154 percent between 2009 and 2010. Growth continued to slow in the first quarter of this year — revenue increased just 45 percent from the year-earlier quarter.

And the company’s earnings are bearing the weight of the costs of growing — marketing, administrative costs, research and development (R&D), etc. Net income grew 65 percent from 2010 to 2011, to $1 billion. But in the first quarter of this year those costs weighed on the company’s balance sheet, pushing net income down 12 percent from the year ago quarter to $205 million.

How does Facebook make that money? The vast majority comes from advertising — responsible for 82 percent of revenue in the first quarter of 2012. The company appeals to advertisers with its reach, but even more important, the fact that it can target ads with “relevance,” based on all the personal information users decide to share. Perhaps more interesting, Facebook can target ads with ‘social context’ — which means highlighting users’ friends connections with a brand or business. And people are much more likely to respond favorably to a message if they know a friend has endorsed the brand or just “checked in” at a store.

What’s the future of Facebook’s ad business? It all depends on how well those ads work for marketers. But Facebook says that its potential share of the nearly $600 billion global advertising market is huge, because it doesn’t just compete with other online display ads, but also can compete with traditional offline advertising. The big question here, is how well its mobile ads work, and whether they annoy users accustomed to an ad-free mobile experience.

The rest of Facebook’s revenue comes from payments — Facebook takes a cut when users buy virtual goods on games — like a cow purchased for Zynga’s Farmville. Users put in their credit card information to purchase those goods, and Facebook takes a 30 percent cut of Zynga’s revenue, and a roughly similar cut from other companies.

How big a business is this? The worldwide revenue from sales of virtual goods is expected to hit $15 billion in 2014, and Facebook aims to get a growing percentage of that market. Right now Facebook only takes a cut of payments for games. But the company says it “may seek to extend payments to other types of apps in the future.”

I’d expect retailers and entertainment companies to start offering more on the Facebook platform — movies, live concerts, and clothing — and for Facebook to start taking a cut. It won’t be able to take the same 30 percent it gets from Zynga , but if say, J. Crew, starts offering shopping without leaving Facebook, if the social network takes even 5 percent, that could be meaningful to its bottom line.

-By CNBC's Julia Boorstin
@JBoorstin