3 of Facebook Inc.'s Biggest Risks for Investors

By Markets Fool.com

Investors who bought Facebook early and held onto their shares can feel very good about that decision. Ground-floor shareholders may have endured a roughly year-long rough patch following the company's 2012 IPO, but the social network's valuation made major gains after delivering blockbuster quarterly results in July 2013. Subsequent pricing gains have far outstripped the dips, and shares currently trade roughly 103% higher than their market debut, while the S&P 500 has gained roughly 59% over the same period.

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Things seem to be going quite well for Facebook and the company's investors. Shares have been roughly flat over the last six months, but they trade near lifetime highs.Mobile businessis booming, andthe company's coreproduct looks as strong as ever, with 1.35 billion monthly active users as of October 2014. Even so, there are still threats to the company that are worthy of consideration. Before Facebook gives its latest earnings report Wednesday, let's look at three of the biggest risks for Facebook investors.

Facebook's ad revenue growth could falter
Whether Facebook can leverage its massive user base to maintain and growan ad network that justifies the company's valuation has been one of the biggest question marks for shareholders and prospective investors. Advertising accounted for 89% of Facebook's revenue in fiscal 2013, and roughly 92% of revenue in its last reported fiscal quarter. The company's third-quarter ad revenue was up roughly 64% year over year.

While the company's advertising model seems to be delivering great results, there are still reasons for a more cautious assessment. Mobile advertising is booming, and accounts for roughly two-thirds of Facebook's revenue, but sales conversion for traditional products from mobile ads remains low compared to desktop alternatives, and it's unclear whether there will be significant improvement on this front.

On the other hand, app install ads have proven to be effective, but the company has chosen not to give a breakdown on how much revenue this segment brings in. This coyness deserves investors' attention. Facebook has to contend with mounting competition from Google and Twitter in the app install arena, and the market isn't that big tobegin with. Google is an especiallylarge threat in this domain, as its control of the Android platform allows it to collect user engagement data that trumps what Facebook can provide. Similarly, Apple's ownership of iOS could make it a formidable competitor for install ads.

Facebook could be disrupted by competing social networks
Social networks are a relatively new phenomena, but there's at least one notable cautionary tale that has surely crossed the minds of most Facebook investors. MySpace was once the biggest player in the social media scene, boasting somewhere in the neighborhood of 75 million users at peak popularity, but the site has since been reduced to something of a cultural punch line.

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Facebook has obviously dwarfed its ill-fated predecessor in terms of user base and monetization, and the strength of the company's network is undeniably leagues beyond that of MySpace at its healthiest point, but the possibility still exists that Facebook will be weakened or displaced by competition. Google+ saw a small increase in third-quarter 2014 user log-ins, while Facebook's log-ins have eroded slightly, though the interconnected nature of Google's online platform likely lessens the usefulness of that indicator. What is clear, however, is that Facebook has been losing teenage users to Twitter and messaging services like SnapChat. The migration of young users signals the possibility that Facebook's network effect will weaken.

Facebook has issued a lot of stock to fund its acquisitions
The possibility that Facebook's core product will be displaced creates a need for diversification, but the company hasn't done a great job of building its own new products. Apps like Camera and Paper have fallen flat, so the company's most important efforts to broaden its base have come by way of acquisition. Of the $22 billion Facebook paid to acquire messaging service WhatsApp, roughly $18 billion was paid in stock. The company's $2 billion acquisition of virtual reality company Oculus VR was also funded mostly with stock, and Facebook has increased its total shares outstanding by 30.39% since its IPO.

FB Chart

FB data by YCharts.

Facebook's use of stock for acquisitions heightens the possibility of big sell-offs. The stock used in the WhatsApp and Oculus acquisitions alone accounts for a significant portion of Facebook's $216 billion market cap, and there's reason to believe that additional dilution will occur. Facebook needs to stay at the forefront of the social Internet, and its purchasing spree is likely to continue.

The article 3 of Facebook Inc.'s Biggest Risks for Investors originally appeared on Fool.com.

Keith Noonan has no position in any stocks mentioned. Though Keith owns no shares of Facebook, he does occasionally share on Facebook. The Motley Fool recommends Facebook, Google (A shares), Google (C shares), and Twitter. The Motley Fool owns shares of Facebook, Google (A shares), Google (C shares), and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.