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Debunking the Latest Predictions of Facebook’s Demise

Every few years, a strange affliction breaks out in Silicon Valley. The disease, Facebook Second Guessing Syndrome, has as its worst symptom an embarrassing tendency to predict an early peak for the fortunes of the world’s largest social network.

To techies who laud Apple for its hardware and software design or Google for its data prowess, Facebook has long looked a little frivolous and more than a tad faddish. The company’s genius is in bringing people together and persuading them to stick around, an unusual skill in Silicon Valley, and something Mark Zuckerberg’s company has done consistently for over a decade.

That’s despite various potential threats to its dominance — the rise of alternative social networks, a shift from desktop computers to mobile phones and the perpetual technological fickleness of young people. Facebook has even managed to reap substantial profits from its operations, beating analysts’ expectations in every quarterly earnings report over the past two years. Its market valuation recently surpassed $230 billion, passing JPMorgan Chase and within striking distance of General Electric.

Yet the skepticism persists.

Now, as the company holds a developer conference this week in San Francisco, another theory arguing that Facebook’s success may be illusory has been making the rounds. This theory concerns the rapid sales growth in Facebook’s ads in its smartphone app, the most used app on the planet.

The trouble, the theory goes, is that Facebook is increasingly depending on these ads, many of which are run by other start-ups hawking their own apps. For some industry observers and market analysts, Facebook’s reliance on money from other app companies looks like the making of an unsustainable monoculture — not a lasting business, but something spun up in the heady froth of a venture capital smoothie.

“There are now a number of revenue streams that are being driven by venture dollars,” Bill Gurley, a prominent venture capitalist who has been warning of a tech bubble, said recently in an onstage interview at South by Southwest in Austin, Tex. “Facebook and a little bit of Twitter’s revenues are now coming heavily from mobile downloads. These are ads for, like,Game of War with Kate Upton. Those ads are now an increasing percentage of their revenue, and they’re being spent by these excessive venture dollars.”

The notion that Facebook and other social networks will suffer most deeply when the bubble bursts sounds plausible because it rehashes the last tech boom and bust, when advertising revenue run-ups at huge web portals (remember those?) turned out to be funded mainly by venture capital investments. In 2001, revenue at Yahoo — the largest portal, and something like the Facebook of its time — plummeted by almost $400 million when start-ups stopped spending during the bust. Yahoo has never recovered its former glory. Could Facebook face the same fate?

Probably not — or not yet, at least. On closer inspection, the theory that Facebook’s growth depends on unsustainable venture capital is mostly overblown, another strain of Facebook Second Guessing Syndrome. It’s a story that misses important facts about Facebook’s advertising business. For one thing, as Facebook’s executives have repeatedly pointed out, ads from app companies make up a small percentage of the company’s overall business. Most of the social network’s revenue comes from video ads and ads for large brands.

The theory also misses two other points. Not all these ads are coming from unproved start-ups. And the ads are set to be adopted more widely because they actually work.

According to several app makers and observers of the industry, the ads are tremendously effective at leading paying customers to new apps. It’s the effort to reach these paying customers — and not venture funding — that is often the reason for all the money pouring into ads for apps.

App-pushing ads are known in the industry as app-install ads. They appear in your Facebook News Feed or Twitter stream and encourage you to download apps from companies that make mobile games and e-commerce and travel services; they also come from big brands like Target and Chase. When you tap the ad, you are sent to Apple or Google’s app store. Facebook and Twitter are paid for each click according to prices set by an online bidding process.

According to Cathy Boyle, an analyst at eMarketer, a research firm that studies the online advertising business, the market for app-install ads is growing rapidly. Ms. Boyle estimates that in the United States, app companies spent $1.67 billion on install ads in 2014. She expects that number to grow 80 percent this year, to about $3 billion. The market for app-install ads is growing faster than just about any other digital advertising category, Ms. Boyle said, but it is still relatively small. In 2015, these ads will account for about 10 percent of the American mobile ad market, according to eMarketer.

Facebook and Twitter would not specify the proportion of their revenue from app ads, but both have described it as far from the majority of their business. “We talk about our mobile ad business growing — mobile app ads are a small part of that, growing in line with our total business,” said Sheryl Sandberg, Facebook’s chief operating officer, in a call with investors in October.

One reason spending on these ads is growing is that the ads solve a problem faced both by businesses that make apps and by users who want apps: App stores are becoming ever more crowded, and it is increasingly difficult for new apps to find an audience. In this way, apps for ads on social networks perform the same function as the highly successful ads for websites that Google runs alongside its search results — they show people something that they might click on and pay for, based on a combination of users’ interests and a business’s willingness to pay.

App ads are also like search ads in that they are highly measurable. Marketers can target specific types of customers whom they want to present with an ad for a certain app, and they can also track exactly how much money they make from customers they get through an app ad. By contrast, the advertising boom that doomed the portal industry was not built on measurable ads. Those were mostly web banner ads, whose effectiveness has always been something of a leap of faith.

Acquiring new customers through app ads is “100 percent based on data,” said Bernard Kim, senior vice president for social and mobile publishing at the video game developer Electronic Arts. “We have the ability to track the players that we get through these networks very carefully, and we know what the profitability looks like on a player, so these ads are a very effective tool for us to bring in the players that we want to engage with our titles.”

Skeptics remain. One tech investor who has been critical of these ads pointed out that start-ups are often very bad at calculating the long-term value of new customers. This miscalculation often causes them to overspend on marketing. Several recent venture-funded flops, including Groupon and Fab.com, were tripped up by huge marketing spending that did not lead to lucrative long-term customers.

If today’s money-burning, venture-funded app companies — Uber, Lyft, Airbnb and many more — are also overestimating the value of new customers, could they wake up one day to find they’re spending too much on app ads?

Facebook does not think so. In an interview, Andrew Bosworth, the company’s vice president for advertising, argued that start-ups today were more disciplined than in the recent past, with many analyzing not just how much they’re spending to get new users but also whether those people are actually buying stuff. “That’s been the big shift. The big V.C.-backedFab.coms of the world spent on acquisition but couldn’t actually convert,” he said. But when today’s start-ups look at these ads, “They’re asking, ‘Can you put a dollar in and get two dollars out?’ If you can, you spend, and if you can’t, you don’t.”

Sure, Mr. Bosworth’s argument is a variation of “this time is different,” which is the stock defense during every boom. But he added that Facebook wasn’t counting on app ads for its long-term survival. “I think this will be a stable ongoing market,” he said. “I think it will plateau at some point in terms of share, as smartphone growth plateaus. I don’t think it will shrink dramatically, but I just think there will come a point where it plateaus.”