How Google Makes Money

Executive Summary


This article and podcast answers the following questions:

  • What is Google’s primary means of revenue?
  • Why does everybody win with Google Adwords and Google Adsense?
  • Why is data driven arguments the driver behind Google’s business model?
  • Ask The Investors: How do we calculate opportunity cost of stocks?

This article provides an overview of the book, In The Plex, which is an account of Billionaire’s Larry Page and Sergey Brin’s development of Google. If you want to read our executive summary of, In the Plex, view this page instead. If you would like to download all of our book summaries, click here.

Google made a whopping $60 billion in sales in 2013. As you may know, the company has released Gmail, Docs, News, Hangout, Maps and loads of other products, but where does the revenue come from? When Larry Page and Sergey Brin founded the company, they focused completely on search. The idea was a hit amongst many of their peers, but they had to find out a way to make money. While Google helped its users, they had to make profits too, and that’s when they forayed into the world of advertising. Technically, Google accumulates about 93% of its revenue through advertisements – a feat its rivals (other search engines) failed to grasp. Another important factor is Google’s scalable nature that encourages growth beyond belief. Google’s search engine is capable of answering almost any question, and by knowing that, the company rakes in huge revenues by the advertisements it places alongside the results.

Adwords

So what is AdWords? Let’s assume that you are shopping for a tennis racket. Once you type in ‘Tennis Racket’ as your query, you will notice several advertisements on the top and in the top right hand side of your page. These ads are also marked ‘Sponsored’ so that it doesn’t affect organic search results. The sponsored ads you see is a service provided by Google to help businesses place their ads on Google and its network.

Of course, there are different ways to place those ads on Google, but the idea is to provide a legitimate way to increase the exposure of several businesses. The AdWords program allows businesses to set their own budgets for advertising.

What is the business model of Adwords?

AdWords has worked like a boon for Google and one can’t even imagine the impact of AdWords on several small and big businesses. Over the past 10 years, AdWords has provided incredible advantages to its users, enabling Google to emerge as a behemoth in the internet world. Basically, AdWords is an intelligent advertising model that offers transparency and profitable returns for both Google and the advertisers.

AdWords has been main responsible for Google’s success. With its ability to generate about 70% of advertising revenue, it has empowered the company to focus on other ventures – like autonomous cars. Although there are several reasons behind the success of AdWords, the most important and obvious one is the fact that it aligns perfectly with the open internet.

Google grasped the opportunities offered by the internet and exploited online advertising to their advantage, while other companies let it slip through their hands. Even before Google conceived AdWords, online advertising existed, but it was conducted in a way that was similar to the offline world. Therefore, as AdWords operated in association with the internet, it was a perfect arrangement for the users, businesses and, of course, Google.

Though AdWords appears like an application that allows marketplace bidding, it has a lot more potential than meets the eye. It is a combination of several key ingredients that work as a team to produce an efficient business model. The ingredients are:

1. Customer’s choice One of the best features of AdWords is that it allows a customer, the advertiser of AdWords, to choose whatever campaign he wants. A customer can interact with Google on his own, instead of operating through traditional, offline techniques. One doesn’t have to be technically bright to interact and develop a profitable relationship with AdWords, since the entire process is easily understandable, and depends on self service. Google deserves a lot of credit for inventing a business model that didn’t even compete with the advertisement agencies. It wasn’t even necessary for Google to try and convince customers to place ads because the model would work based on the customer’s requirements.

Business owners can choose specific keywords that are relevant to their website. For example, if an individual owns a bakery, he can choose keywords such as ‘cupcakes’ or ‘pastries’ and connect with customers who are interested. Then AdWords searches for sites that display those keywords and in turn places these ads there. In this manner, AdWords helps the business owner generate revenue through its cost effective online advertisements.

2. Well worth the money It’s important for Google and any other successful business for customers to feel that the price is fair. But how is the price for AdWords determined, you ask? Well, think of it in terms of real estate. If the demand for a priced property increases, the value rises proportionally and vice versa. Similarly, the price of a keyword is directly proportional to the demand, making it a fair, economic business model. In addition, it lures the customers since they don’t have to spend buckets of money for advertisements. If the customer had to achieve the same outcome in an offline world, he would have to spend a lot of money since the price is usually determined by the host.

Google has created several products over the years and though the company has spent billions of dollars on its products, they provide access for free. Among such products, Google Analytics has gained a lot of recognition since it aligns perfectly with AdWords. As customers spend hard earned money on advertisements, it makes sense to use tools that help them track how their investments work. Google Analytics provides all the tools necessary to help the customer build an effective ad campaign and blow competition out of the water. By investing in these products, Google helps customers get an exact breakdown of how their money is being spent. This in turn, allows them to see and get more information about the performance of their ad campaigns. Therefore, customers are happy campers since they get a lot more in return for their investment. As they say at Google: “The more they know – the more they buy”.

3. Everybody’s a winner Google strategically places business owner ads in prominent locations to create more exposure. This clearly gives an entrepreneur using AdWords an advantage over the organic search results and enables him to outrank competition. Consequently, marketers who yearn for maximum exposure bid more aggressively to secure the best spots in the entire network. As demand increases, the prices go higher and business owners can push in more money in their campaign and secure premium spots.

Naturally, this tempts several business owners to plow money into their ad campaigns and Google earns more revenue. Similarly, the business owner also gets a better chance to gain exposure as millions of customers are likely to view his ads. While Google and the advertiser makes profits, the users who types in queries also benefit from the process since they ultimately get what they want. Thanks to this simple marketplace, AdWords clearly makes everyone a winner.

4. Flexible Budget AdWords offers total freedom to the business owners, allowing them to select campaigns with different budgets. Any customer who chooses to use AdWords can invest any amount, depending upon his requirement, and set a predefined amount that cannot be exceeded. In addition, customers don’t have to speculate if they pay for an ad that no one sees. Simply put, ‘No visit, no fee’, explains it all. This means that an advertiser only pays when someone clicks the ad to visit the website. Therefore, he doesn’t have to pay a penny more or less than the budget he chose. In other words, he can continue to use AdWords until it works and in the unlikely case that it doesn’t, he can simply stop using it. He can also choose among various campaigns that provide local and global advertising facilities.

Auction – As you may know, auctions are an important part of the AdWords business model. Basically the auction system is used to rank the ads appearing on the search results. Google recognizes an important factor called ‘relevance’ and displays ads that are relevant to the content, as mentioned earlier. In addition, Google also focuses on providing a good experience to the users who expect to view relevant content. This also ensures that the user is happy with the experience and returns to Google for future business or search queries.

Once a user types a query on Google, the request is processed by the search engine. At this point, the CPC or the Cost Per Click and the ad positions are also determined. An advertiser is eligible for the auction only when he bids on keywords that are relevant to the user’s search. Apart from that, an advertiser’s quality score and bids also play a major role in determining whether the ad qualifies for display. The quality is determined by the advertiser’s landing page. An advertiser with a good landing page that contains well written, original content, has a better chance to be placed in a high position. The advertiser also needs to ensure that his site is easily navigable. Advertisers who bid with low quality scores can be penalized by Google, but conversely, advertisers with higher quality scores receive lower CPCs and higher ad ranks. At this point, Google also predicts the number of clicks an ad can generate. The company relies on users to determine the best ads and thus, the expected click-through rates are calculated. The number of clicks for an ad gives a clear indication about the user’s response and since billions of users use Google, the task becomes considerably easy. In other words, the best ads for every search query are determined by a higher user response.

Let’s assume that there are three advertisers named David, Robert, and Peter. While David bids $5 for an ad, Robert bids $4 and Peter bids only $3. Technically, David has the highest bid and will expect the highest position, but with AdWords auction, he doesn’t have to pay $5 to bag the first position. David can just pay $4 since that’s the amount from the second highest bidder aka Robert, in this case. Similarly, Robert needs to pay only $3 to get the second position and so on. This model allows everyone to participate since everyone gets to choose a spot. Clearly, it is beneficial for advertisers because they only need to pay the true value of an ad, which is just enough to outrank the competition. However, individuals with the lowest bids need to pay whatever they bid. In this case, Peter will have to pay $3 since he was the lowest bidder. This rule also applies to individuals who are lone bidders in the auctions. However, it is important to remember that the ad rank doesn’t depend on the bid alone. Google also considers the impact of the Ad formats to determine ad rank. Basically Ad formats are enhancements that show an advertiser’s site, including phone numbers and addresses, more prominently to the users.

Let’s take this example again. Sure, David clearly has the highest position with his high bid, but if his ad rank is lower than the other bidders, his ad will be placed in a lower position. The advertiser’s CPC is determined in this way, thereby enabling them to even pay lower than what they bid, thanks to their ad ranks. To summarize it all, the landing page, bid, transparency, ad relevance, expected click-through rate, and quality are key components that determine the advertiser’s ad rank.

Google knows you – Today, few people remember a time on the Internet when Google was not the most used search engine. Google’s success can be attributed to the fact that it focuses completely on the customer’s requirements.

There were times when baffled users complained about Google’s nosy behavior when they saw relevant ads placed on their search results. However, everyone seems to understand the importance of such ads today. As the search engine grows smarter every day, it delves deeper into people’s lives and behaves human-like. It also recognizes the results that could help the user since it is aware of the user’s needs. As human beings, we possess the ability to think smart, but we encounter many limitations when it comes to handling huge chunks of data. However, since Google has the capability of handling data and thinking smart like a human, it has managed to combined the best of both worlds effectively. Most importantly, Google’s ads aren’t senseless ads that don’t benefit customers, but instead, Google’s ads also act as important resources of knowledge, delivering more information and value to the customer and user. In fact, if an advertisement is performing well (with a high click through rate), Google algorithms may automatically move the landing page into organic search results.

AdSense

AdSense is another advertising service implemented by Google. AdSense operates on a very simple concept and is designed mainly for website owners wanting to display video, image or text advertisements on the pages of their website (thereby earning money when users click the ads). AdSense works as a perfect monetization technique for billions of users across the world since it’s so easy to set-up.

As mentioned earlier, Google gathers its revenue by using AdWords, where they display ads as ‘Sponsored results’. Based on the auction system, advertisers get a chance to be placed on the search results. AdSense allows users to share Google’s revenue earned through AdWords. When an individual places the same image or text ads on his site, AdSense shares a certain percentage of the revenue with him. It’s as simple as that. Website owners who use AdSense don’t have to worry about the ads since Google manages and controls the ads. Google’s secret algorithm reviews the content of a site and then places relevant ads. The website owners need to simply create an AdSense account and add a snippet of code on their sites to display the ads. As always, Google offers various kinds of AdSense programs to help advertisers generate revenue.

What is the Business model for AdSense

AdSense, generates about 30% of the advertising revenue for Google. Google pays about 51% of the revenue generated by advertisers to the website owners. This means that if an advertiser pays $100 to Google, Google keeps $49 and gives $51 to the website owner.

Basically, you can add a snippet of code in your website and create ad spaces. You can change the colors, fonts, and themes, depending on your personal taste and also get to choose where you want the ads to appear. At this point, an auction takes place where advertisers bid and compete against each other to gain some ad space on your website. As a result, you get paid after Google handles all the process of billing all the advertisers who placed the ads on your site.

AdSense works on a concept that is very similar to AdWords. Like AdWords, AdSense also ensures that everybody’s a winner. For example, if you use AdSense and allow advertisers to place ads on your website, Google generates revenue and pays a percentage to you, thereby helping you earn some money. In turn, the advertiser gains more exposure due to his ads on your site, thereby helping him gather more revenue. Ultimately, the user also benefits because the advertisements are relevant to their interests. Therefore, AdSense works like AdWords, and is a profitable tool for Google and millions of users, website owners, and advertisers.

To expand on that, take a look at how AdSense works for everybody in the equation.

Website Owners – AdSense works on a simple concept that allows everybody to participate no matter how little traffic you have. Since it doesn’t take a lot of time and is free and easy to set up, website owners don’t have to worry about anything else, and Google manages everything for them. At the end of it all, it’s just a question of how much money the owner can make. It is important to understand that AdSense is not a scheme to get rich quickly. However, if the owner focuses on relevant, original content, he/she will be able to draw loads of users to the site eventually and use AdSense to generate a good income. In fact, AdSense is a boon for individuals with small businesses who don’t have the resources to employ numerous employees and generate sales through advertisements.

Google – Since Google invests billions of dollars in its products to help millions of users, they need to make a good return on their investment. While Google sets up a scalable system for users, AdSense provides a great return on investment to the company, thanks to the users, website owners, and advertisers using the program.

Customers – Google is very picky about the ads it displays, and this means that it focuses completely on the relevance of the ads in order to provide a great experience to the end user who clicks on the ads. Typically, when the user types in a query, he/she won’t just see mere ads, but the ads themselves work as search results. For example, if the user types in ‘Cupcakes’ as the search query, he can expect to see ads placed by bakery owners, and this makes it easier for the user to gather information or purchase whatever he wants.

Advertisers – If you understand the AdSense program, you probably know that the advertisers are the most important elements in the entire process. Basically, they run the show by paying for the ads and generate income for Google and website owners, but in return, they also earn profits through their ads. The advertiser tends to spend more on the ads if he/she generates a profitable income and Google also helps the advertiser by providing various tools and data as Google relies completely on data. You can read more about how Google uses data to its advantage in the section below.

Data Driven Arguments

As you may already know, AdSense could work as an excellent program for many people to monetize content. While some people generate average income, others accumulate sizeable incomes only through AdSense. As the model is completely based on a self-service system, the revenue depends on how the individual uses AdSense. To make the process easier, Google provides various tools to advertisers and website owners, enabling them to generate more revenue. Over the years, Google has displayed its love for data since the founders believed that the data doesn’t lie. Similarly, they provide valuable data in the form of tools to provide various opportunities to the site owners and advertisers. Let’s take a look at the various tools offered by Google:

AdSense Earnings tool – This free and simple tool allows users to monitor their AdSense earnings effectively. As the users can view all their earnings whether it’s generated on a daily, monthly or yearly basis, this tool definitely provides more information to the user.

AdSense Preview tool – This tool allows users to preview any ads that may appear on web pages. The user can make educated decisions as to whether he can use AdSense to his advantage, using this tool.

Keyword tool – AdSense has the potential to generate sizeable revenue if the website owner targets keywords that pay higher than the usual keywords. This tool helps users target high-paying keywords, depending on the domain names specified.

WordTracker – As you many know, users type in different queries every time they search for something. This means that they use different keywords to get what they want. By using this tool, website owners can easily target keywords that are most effective and include that in their pages. Though this tool isn’t free, you can opt for the free trial and figure out if it works for you.

AdSense Calculator – This tool is designed to help users predict any increase or decrease in their page impressions, CPC and click-through rate.

Google has released various other tools to help website owners and advertisers rake more income; however, only a few of those tools are explained above. Clearly, Google encourages both the advertisers and the website owners to use these tools and make more money subsequently benefitting Google through more paid clicks.

Costs

Now that you know what you need to know about where Google’s revenues come from. 20% of that enormous revenue ($60 Billion), turns up as profit on the bottom line. 20% is actually a massive net profit margin that most companies would envy. To fully grasp the fundamental advantage with Google’s cost structure, think of the contrary business model. A baker needs twice the amount of flour to make two breads instead of one. Google is very different. They don’t require twice as many engineers to handle twice as many searches. Google’s business model is simple create to scale! As you will see explained below many of the companies expenses are not paid unless Google for sure know that they will get more back in return.

The costs are divided into many categories; however, traffic acquisition costs take up a major chunk of the costs for Google. Google, like other search companies, has to pay affiliates and other distribution partners who drive traffic to Google. Traffic Acquisition Costs, also known as TAC are critical for search companies such as Google, Baidu (Chinese search engine), and Yahoo since investors and analysts use TAC data to determine whether the costs are declining or rising. This simply means that the TAC has a direct effect on the profitability or loss of a company.

Payments for website owners who promote AdSense – Google spends 42% on its TAC and while this may sound like a huge number, the company’s real estate (search pages) seems to be a saving grace, enabling them to cover most of the costs effortlessly. Oddly, Google spends a lot more on AdSense when compared to AdWords but since they use their own search pages, at least 75% of their acquisition costs are again covered here.

Distribution partners – Google also pays its affiliates and other distribution partners who advertise their products and drive traffic to the company. Although this takes up about 25% of their costs, the cost is again covered here for Google. Of course, a distribution partner receives a staggering 68% of the revenue as commission; however, Google stand to generate higher revenues from this as the partners are paid to advertise products from Google.

Operating expenses – Over the years, Google has plowed a lot of money into its infrastructure. Thanks to its secretive nature, Google has never disclosed the amount of data centers it owns all over the world. However, executives in Google have stated that the company is one of the biggest computer manufactures in the world, outranking even companies such as Dell whose main business is to manufacture computers. Obviously, Google has many other costs apart from its TAC, and like any other company, the costs fluctuate depending on the amount they invest in the R&D and other critical areas.

Larry Page and Sergey Brin founded Google with the vision of making the world a better place. Over time, Google grew into an internet giant, outranking every other company. Several analysts and investors criticized and doubted the company’s growth, but Google has managed to outsmart competition only because it completely understands the user’s requirements. With its focus on the customer, Google has achieved heights that seem impossible for other companies.

It is difficult to measure Google’s process, operation, and growth since it delves into areas that are far beyond our imagination. It isn’t possible to explain the depth of Google’s culture; however, Google tends to arouse people’s curiosity due to the way it thinks. If you are interested to find out how the colossus works, behaves, and shapes our lives, you can download our complete PDF-summary of the book, “In the Plex” here.

Ask the Investors: How to calculate opportunity costs of stocks?

Understanding how to calculate opportunity costs is the key to optimize returns for stock investing. The idea is very simple. If you own stock in a company that you expect to get a 5% return from, there would be an opportunity cost if a second choice arose at a higher return (say 7%). One of the most important factors to account for with opportunity cost is the capital gains tax that would be paid upon the sale of the existing asset. This needs to always be factored into any decision. Since this can be a confusing topic for people, we have made a free video and calculator for you to use at the following address.


Books and resources mentioned in this episode

Hari’s Blog: BitsBusiness.com

Hari & Preston’s discussion on Motessori Schools

Steve Levy’s book, In The PlexRead reviews of this book.

Brad Stone’s book, The Everything StoreRead reviews of this book.

Charles Koch’s book, The Science of SuccessRead reviews of this book.


The History of Google


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