Does Google deserve a high multiple?
A few week’s ago, I wrote an article about venture capitalist Bill Gurley’s business traits which determine whether a company deserves a high-multiple valuation. As I wrote in the article, “The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.”
Here’s my take on how Internet juggernaut Google stacks up against Gurley’s criteria.
1. “Sustainable Competitive Advantage (Warren Buffett’s Moat)”
I just finished reading Steven Levey’s excellent book In The Plex: How Google Thinks, Works and Shapes Our Lives. The book is must reading if you are interested in Google. It was also recommended by Charlie Munger who thinks highly of Google’s moat. I’ve written before on the strength of Google’s moat.
Google is the leader in search, and they work hard at keeping it that way.
Googlers continually measure the effectiveness of their search algorithm by analyzing whether it achieves a good outcome. Basically, they judge a search to be successful if a person quickly selects a link and “goes away”. Multiple successive clicks indicate dissatisfaction.
Based on these observations, Google is constantly tweaking its algorithm and running hundreds of simultaneous tests on small but meaningful subsets of their users. If a tweak improves the outcome, it is rolled out and another baby alligator is added to the moat.
This Darwinian process makes it tough for someone to catch up and pass them. In The Plex sheds light on the large number of significant search problems that Google has already solved. Cumulatively these comprise a strong moat.
That being said, a technology centric company like Google will always be more susceptible to disruption than an entrenched consumer product company such as Coke or Wrigley’s.
Google’s data centers are another source of competitive advantage. Google is in a unique position to deliver globally-synchronized data in real time at a cost that is materially lower than it’s competitors.
According to In The Plex, “By perfecting its software, owning its own fiber, and innovating in conservation techniques, Google was able to run its computers spending only a third of what its competitors paid.” (Levy, Steven (2011). In The Plex, p. 198) [emphasis added]
Is also worth mentioning that the Internet seems to favor companies that establish an entrenched position. Amazon, eBay, Google, and Facebook have all proven difficult to disrupt by their rivals.
2. “The Presence of Network Effects”
When a product or service enjoys a network effect, the utility of the product or service increases as the number of people using it increases.
Google benefits from a network effect.
The more people who use Google, the more data it has to improve its search results and related products such as Google Translate. This leads to happier users who are more likely to continue to use Google because they are increasingly likely to find what they’re looking for.
Advertisers benefit from this because the more people who use Google, the more likely it is that users will click through and purchase something. The more advertisers there are on the system, the more likely it is that Google can deliver a relevant add to a user when he or she does a search.
A Darwinian ranking system of multiple variables continuously ranks ads and rewards better ads with better placement, further reinforcing this virtuous circle.
3. “Visibility/Predictability Are Highly Valued”
In business there is a continuum between highly predictive sources of revenue – such as a subscription based service – and one-off, non-recurring lumpy revenue – such as a business that sells major construction projects and which can only expect to sell a few per year.
Obviously the former types of business will sell at higher multiples – all else being equal – because their revenue is more predicable.
Google enjoys highly predictable revenue because it operates as a kind of toll-booth on Internet advertising, and its revenue is derived from millions of individual advertising clients – none of which controls more than a tiny fraction of Google’s overall revenue.
Moreover, just like there is a hard limit on prime real estate such as beachfront property in Los Angeles county, there is a large, but limited number of key words that drive Internet commerce. Google controls the lions share of this “real estate” for these invaluable search words.
It should be noted that advertising revenue is tied to the general economy and as such is cyclical. Google did experience softening revenues in the latest recession although this was mitigated by the strong secular growth in both Internet usage and advertising.
4. “Customer Lock-in / High Switching Costs”
There is nothing that locks users and advertisers into using Google in the classic sense of switching costs. This may slowly change as more users adopt Google applications such as Docs and Gmail. Google’s + initiative, if successful, may also make Google’s offerings more sticky.
The real issue is that, if an advertiser leaves Google, where do they go? Leaving Google means conceding visibility to your competitors for the 65% of Internet users who use Google in the U.S. and a much higher percentage in numerous other countries.
(to be continued in a second part)