Business Background
In 1995, Stanford classmates Larry Page and Sergey Brin founded BackRub (which later was to be renamed Google). The name Google came from a misspelling of the word “Googol”, which means a one followed by one hundred zeros. Page and Brin initially chose Googol because of their PageRank theory where they could rank search results based on links on web pages.
In 2002, Yahoo tried to acquire Google for $3 billion. Google declined the offer and thought they were worth closer to $5 billion. In 2004, they IPO’d with a valuation of $27 billion and today the entire company is worth well over a trillion dollars.
While Alphabet (Google’s holding company) has many businesses, this article will focus on its first and most valuable business, Google Search.
Business Overview
Google advertising generates revenue in three different ways. The Google Search segment is when a user searches keywords in Google Search and occasionally paid links show up before organic results. The majority of Google’s ad revenue comes from Search, however, Google Network (which primarily includes AdSense), and YouTube still generated a combined $60 billion in revenue last year.
Google Revenue
Source: Google 10K
Acquiring Users
The search industry has two distinct sides to it where Google is the middleman. They need to acquire users onto their search network, and they need to acquire advertisers to serve ads to those users. Each side of this marketplace has distinct industry trends and should be viewed differently.
Industry Overview
Google has a greater than 90% market share in the search industry while the next closest competitor, Bing, has just over 3% market share. To highlight Google’s lead in search, the most common use of Bing, was to get to Google’s search engine. “Google” was Bing’s most common query.
Of the other competitors on the list, Baidu and Yandex each have carved out niches in the countries of China and Russia respectively. They are given political preference which has allowed them to gain market share. Baidu has an 84% market share in China and Yandex has 50% market share in Russia. Excluding these two countries, Google’s market share is significantly higher.
Global Search Market Share
Source: Statcounter
Google’s market share over the past decade has been extremely durable. They have had greater than 85% market share in search every month since 2009. They have multiple competitive advantages protecting themselves from competition
Google Market Share
Source: Statcounter
Industry Trends
Digital Advertising is a very cyclical industry. When times are good companies spend extra money trying to produce extra sales, however, when times are bad, ad spend is one of the first things companies cut. Snapchat is a prime example of it. Embarrassingly, a month after giving their quarterly guidance, they released a letter to shareholders stating they will miss it blaming macroeconomic factors.
Source: Kaushik
While Google is not a mismanaged company like Snapchat, they are also at risk of missing guidance. Despite all these well-known macro headwinds, the sell-side has not lowered Google’s sales estimates much. In my opinion, sell-side cuts or a missed earnings report are likely putting short-term pressure on the stock price.
Google Sell-Side Estimates
Source: Koyfin
Competitive Advantage
Google has multiple moats protecting its dominant market share in search. These include being the default search engine, a cognitive referent, their scale, and their speed.
Default
In 2016, about 60% of all searches were done on mobile devices. That number has surely grown since then. Google has a giant advantage in mobile search as they are the default mobile search engine. >99% of the world’s phone users use an Android or iOS operating system. In countries that allow it, Google is able to make itself the default search engine for all Android phones. Google has also made a controversial deal with Apple where they pay between $18-$20 billion to be the default search engine on the iPhone.
Many investors see this as a risk as Google is dependent on Apple, but Apple is also dependent on Google. This deal represents ~20% of Apple’s net income and losing that would be a significant blow. No other search engine could responsibly afford this deal. They do not have the digital advertising expertise that Google has to recoup the $18-$20 billion and turn a profit.
Mobile Phone Operating System Market Share
Source: Statcounter
Cognitive Referent
The word Google has become synonymous with search. People often say to “Google” something instead of search. Google has become its own verb in Webster’s dictionary and a cognitive referent. People do not think twice about what brand they want to search with, it is implied that everyone uses Google. Google receives free advertising from people’s everyday conversations.
Definition of Google
Source: Merriam-Webster
Scale
Google’s search engine has crawled through many more web pages than the competition. Google has indexed hundreds of billions of web pages while Bing is estimated to only have crawled through 8-14 billion web pages. Some might wonder why a search engine needs more than 14 billion web pages, but those people are underestimating all the different use cases and needs for Google.
“Every year, there are trillions of searches on Google, and 15% of the searches we see every day are new” – Google 10k
The other advantage of scale is predicting which results to serve to users. With all the diverse search options, Google is better able to serve relevant search results to its users. With a greater than 85% market share in search over the last decade, Google is able to collect more data than its competitors, thus, creating more relevant search results.
“Google Searches are powered by machine-based algorithms that take into account users’ previous search history and location when generating results.” - Search Engine Journal
Speed
It is tough to measure, but pretty well accepted that Google is the fastest search engine. Google can return billions of results in under a second. While speed is mostly a product advantage, it would take time and capital to replicate. While it is possible for another search engine to replicate Google’s speed, it is an additional barrier that competitors need to get around.
Digital Advertising
Once Google has obtained the users, digital advertisers pay to advertise to Google’s users. Multiple trends are supporting digital advertising.
As consumers shift to e-commerce sales, digital advertising should increase as well. Currently, only ~20% of products are bought online. This percentage will undoubtedly grow as distribution improves and companies take advantage of the higher margins and return on invested capital (ROIC) in online sales. Digital marketing companies will be direct beneficiaries of this as e-commerce brands view them as traffic-acquisition costs.
Worldwide Ecommerce Sales
Source: eMarketer
The global digital advertising industry is an oligopoly where five companies make up over 70% of the worldwide spend. Google, Facebook, and Amazon don’t compete against Alibaba and Tencent much as they’re segmented by geographic region. Many more e-commerce brands exist than digital advertising aggregators, thus, giving negotiating power to the aggregators.
Digital Advertising Market Share
Source: eMarketer
Google has massive datasets on each user which allows them to more efficiently target users. These datasets will presumably grow and become more accurate increasing their efficiency and advertisers’ ROAs. Google mainly generates revenue from showing users sponsored results. Advertisers are able to buy keywords and their website shows up first on the results page which allows them to generate traffic to their web page and hopefully monetize later.
One complaint many investors have about a different Google product, YouTube, is how many ads they already show and how could they fit anymore in. Google search is the opposite.
“On 80% of the searches actually, we show no top ads and most of the ads that you see are on searches with commercial intent” – Google 10K
Obviously, many searches have no commercial intent, but it appears that Google has some runway in being able to show their users more ads. Showing more ads to users will allow Google to generate more high-margin revenue.
Risks
Google Search’s main risks come from two different regulatory risks: anti-competitive risks and data privacy risks.
Anti-competitive Risks
Over the past couple of years, Google has paid multiple large fines for its anti-competitive practices, most notably to the EC.
“In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ($2.7 billion as of June 27, 2017), €4.3 billion ($5.1 billion as of June 30, 2018), and €1.5 billion ($1.7 billion as of March 20, 2019), respectively.” Google 10K
The most likely and obvious risk is that Google will continue to have to pay large fines.
Other countries could also favor domestic search engines to make the market more competitive. China and Russia have already done this. Russia is essentially a duopoly between Google and Yandex after policy changes and China is dominated by Baidu. If this trend of nationalism continues, Google’s monopoly-like status could be threatened in other foreign countries.
Data Privacy Risks
Consumers and politicians are becoming more concerned about data security. Apple’s IDFA change was the first step in the direction of limiting companies’ access to data. Google’s entire business model is based on its access to data. If this were to be impaired by future regulations, consumer preferences, or companies, their ability to target advertisements could be significantly impaired. In that scenario, advertiser ROAs would plummet and Google would not be able to charge as much for ads.
Valuation
Unfortunately, Google lumps the “other” segment in with Google Search. For simplicity, I did not try to remove the other segment as it is a small enough percentage of Google Search and Other Revenue. 2020 was a slow year for Google Search as covid slowed down the entire economy, but in 2021 Google rebounded incredibly. Google unfortunately does not disclose Google Search margins, however, they do show Google Services which includes Google Network and YouTube. Google Services margins ranged between 32%-39% each year.
I think it is a reasonable assumption to believe Google Search is a higher margin business than Google Network and YouTube. Being conservative, I estimated that Google Search’s margins were 3% higher than the segment as a whole. In this scenario, Google Search would have an operating income of $62bn last year. Given Google’s Search’s historical 20% top-line revenue growth, wide moat, but facing tough comps and macro headwinds I believe anywhere from a 16-20X 2021 multiple would make sense. That would value Google Search at $1.11T at the midpoint or about 70% of Google’s total market cap.
Disclosure: I/we have a beneficial long position in the shares of GOOG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.