Tom Monahan, a creativity consultant, who teaches a different kind of thinking called 180-degree-thinking. In this, he asks participants to come up with ideas that don’t work – an oven that can’t cook, a car that doesn’t move. What is the rational behind this?

But the goal of such exercises is not necessarily to generate lasting ideas on the spot; if you do come up with an idea worth pursuing, that’s a bonus. The real point is to begin to train the mind to think differently when confronted with a problem or a challenge— to consider a wide range of possibilities, including offbeat ones, and to connect ideas that don’t normally go together. It’s an attempt to develop and strengthen the What If muscle. As John Seely Brown noted, What If questions tend to free up the imagination because they allow you to “see things as other than they currently are”— they allow you to shift reality, if only briefly. – A More Beautiful Question

Google’s empire is built on such what-if questions. Some of the what-if questions which Googlers asked are (1) what if we could download and index the entire web? Google Search (2) what if we could develop a smarter email service with plenty of storage? Gmail (3) what if we could make a simpler, speedier, safer browser? Chrome (4) what if we could provide easy access to movies, books, music and apps, no matter which device you’re on? Google Play (5) what if we could use a network of balloons that could fly at the edge of space and provide connectivity in rural and remote areas? Project Loon.


1. Business

Google was founded in 1998 with a mission to organize the world’s information and make it universally accessible and useful. It went public on August 2004 with a valuation of $27 billion. As I write this post, its valued at $388 billion. This translates to CAGR of 28.89% every year for almost 11 years. What wave did it surf to achieve such a fantastic result? There were couple of them (1) ads spending moved from offline to online (2) its search algorithm was 10x superior than its competitors.

Google created a powerful search platform using which one can find anything on the internet for free. Along with this it offered other useful services like gmail, maps, and picasa photo album for free. This attracted millions of users to its platform. On seeing this, advertisers spend money on its platform to target relevant ads to millions of users by using Google’s AdWords service. To increase the reach, Google came up with an idea of showing these ads outside its own websites. So it created AdSense service using which third parties can show ads on their websites and earn a portion of ads revenue. These third parties are called as Google Network Members. By allowing three independent groups of customers to interoperate, Google created a multi-sided platform.

In 2014, advertising accounted for 89% of its revenue. Its other revenue accounted for the remaining 11% and this includes digital sales like apps, movies, and music sold via Google Play, and hardware sales like Chromecast and Nexus phones. The good news is that its other revenue grew at 45% over the last 5 years. The hope is that at some point Google will no longer be a one-trick-pony. US accounted for 43% of its revenue and the remaining 57% came from rest of the world. International sales is growing at a faster rate compared to US. Advertising revenue has been growing slower in the recent years.

The reasons for the slow growth are (1) increased competition from social media companies especially Facebook (2) dollar strengthened against other currencies and faster international growth affected the top line (3) revenue from network member websites growth slowed down to 6.4% in 2014; some speculate this is due to the traffic shifting to mobile (4) it’s hard to maintain the growth rate on higher revenue base.




Google delivers two types of advertisements (1) performance advertising; text based ads that appear on Google’s and its partners websites and it gets paid by the advertiser when the user clicks on these ads (2) brand advertising; video, images, and other interactive ads which increases users awareness and affinity towards advertisers products and services; the ads that you see on youtube falls under this category. One major concern is that the cost per click paid by the advertiser has been going down in the recent years. Some speculate this is because of the traffic shifting to mobile and the advertisers are not willing to spend more per click on Google’s platform. But the company doesn’t agree with this and this in isolation does not truly reflect what is going on. I would keep a close eye on this metric going forward.


Goggle costs can be divided into two major parts (1) cost of revenue; includes traffic acquisition costs that it shares with its network members and distribution partners, other costs; content acquisition costs for youtube and Google play, operating data centers, and costs related to hardware sales (2) salaries, bonuses and stock compensation it pays to its employees. From the data shown below you can see that its total costs have been growing faster than sales and this resulted in lower pre-tax operating margins.


In 2010, the company had a pre-tax operating margin of 35%. But in 2014 this came down to 25%. Why did this happen? This happened because in the last five years its gross profit margin went down by 3% due to higher costs it paid to its distribution partners and its media and hardware businesses have lower margins compared to advertising. Also it increased its headcount from 24,000 to 53,600 in five years and this explains the remaining difference of 7%. What is the nature of this headcount expense? It’s fixed in nature and this means that an increase in sales shouldn’t proportionally increase this expense. So in my view one has to look at the normalized expense and not a single year expense. Going forward, I believe it can earn a pre-tax operating margin of around 30%.



2. Moats

In the evolutionary world, genes work by controlling protein synthesis. This is a powerful way of manipulating the world. But it’s very slow. To put a human in place it took billions of years. But changes in the technology world it’s not evolutionary but revolutionary. Things happen at a very fast rate. Take a look at the chart which I got from economist. In the year 2000, who would have predicted that personal computers shipments would slowdown and smartphones will dominate the planet? The honest answer is nobody. At the peak of 1999, Microsoft’s market capitalization was over $600 billion. As of this writing, after 16 years, its market capitalization is $350 billion.


I sometimes laugh when I look at valuations projecting cash flows out for 20+ years. In a world dominated by technology every moat is breached at some point. As an investor, I invest in companies with moats. But I don’t try to predict too far into the future. One of the best ways to see if a company has a moat is to check its return on invested capital (ROIC). From the table given below, we can see that its ROIC came to 36% in 2014. These are fantastic returns. If you don’t believe me, show this to any CEO of an airline company.


Some additional questions that came to my mind are (1) why is ROE much lower than ROIC? Google’s operating business generates tons of cash and it can’t invest everything back into its operations. In 2014, its financial assets generated a paltry 1.29% (2) why did net operating assets increase a lot? It invested a lot in property, equipment, and acquired a lot of companies. The next question is what explains such a high ROIC? Peter Thiel, a venture capitalist, would answer this question in a single word; monopoly.

For example , U.S. airline companies serve millions of passengers and create hundreds of billions of dollars of value each year. But in 2012, when the average airfare each way was $178, the airlines made only 37 cents per passenger trip. Compare them to Google, which creates less value but captures far more. Google brought in $ 50 billion in 2012 (versus $ 160 billion for the airlines), but it kept 21% of those revenues as profits— more than 100 times the airline industry’s profit margin that year. Google makes so much money that it’s now worth three times more than every U.S. airline combined. The airlines compete with each other, but Google stands alone… Think about how Google talks about its business. It certainly doesn’t claim to be a monopoly. But is it one? Well, it depends: a monopoly in what? Let’s say that Google is primarily a search engine. As of May 2014, it owns about 68% of the search market. (Its closest competitors, Microsoft and Yahoo!, have about 19% and 10%, respectively.) If that doesn’t seem dominant enough , consider the fact that the word “google” is now an official entry in the Oxford English Dictionary—as a verb. Don’t hold your breath waiting for that to happen to Bing. — Peter Thiel; Zero to One

From all of the above, one can conclude that Google’s business has a moat. It’s not the existence of the moat but its durability (how long will it last) that’s important. Read this excellent article on the durability of moats. I am going to make couple of bold predictions (1) as long as human beings are alive, advertising will be there. companies cannot sell its products and services without it. why? it’s because of pavlovian associations (2) ads spending will move from offline to online. why? it’s targeted, cost effective, and measurable. On top of this, Google is the leader in search and generates more advertising revenue than anyone. So odds of it maintaining the durability of moat is high. But in technology nothing is certain.

The biggest threat for Google is competition coming from social networking platforms. Why is that? A platform like Facebook knows a lot more about its users. Using this it can target better ads. If the customer engages more with these ads then advertisers will spend more money in Facebook. Google has its own social networking platform called Google+. I am not sure if it can dislodge Facebook’s dominance. As shown in the earlier chart, people are spending more time on their smartphones. This trend will continue forever. The way in which one engages with ads on a smartphone is very different from desktops. Google has adopted to this shift very well and it’s leading everyone. But its overall market share is slowly going down.

Because of limited space in mobile, advertisers prefer display ads like banners and videos. In display ads, Facebook has higher market share compared to Google. We need to watch this trend carefully to see if Google can gain market share in display ads by productively using Youtube. Overall the threat of competition is very high.

3. Management

Larry Page and Sergey Brin cofounded Google. Their founders letters are a treat to read. You can find them here. If you don’t have time, read their IPO letter. Their inspiration for writing this letter came from Buffett’s owners manual. Larry and Sergey together own 14% of the company and control 56% of the votes. From the proxy statement you can see that they received $1 as total compensation from the company. I like to invest in companies that are run by able and honest founders who think long term and are aligned with the shareholders. The letters and the results clearly show that they are owner-operator I.

These are the ideal managers to partner with in a business. An owner-operator is a manager who has genuine passion for their particular business and is typically the founder of that business. These passionate leaders run the business for key stakeholders such as customers, employees, and shareholders alike, instead of emphasizing one constituency over the other. They typically are paid modestly and have high ownership interests in the business. – Michael Shearn; The Investment Checklist

Google has a rule called 70-20-10. Seventy percent of the effort goes to core products like search and advertising. Twenty percent of the effort goes to projects that are promising; Gmail in early days. The remaining ten percent for everything else. What is so special about this? Android came out of this 10% effort and this helped Google to survive the massive shift to mobile. In 2014 Android controlled 75% of the mobile OS market. One can see power law in action.

We are still keeping to our long-standing plan of devoting 70% of our resources to search and advertising. We debate where we should classify our Apps (Gmail, Docs, etc.) products, but they currently fall into the 20% of resources we devote to related businesses. We use the remaining 10% of our resources on areas that are farther afield but have huge potential, such as Android. We strongly believe that allocating modest resources to new areas is crucial to continuing to innovate. This 10% of our resources generates a tremendous amount of interest and press, precisely because these projects are different and new. Often, we find small teams of only a few people suddenly command huge attention worldwide. That’s useful to keep in mind as you read about Google-the vast majority of our resources are working on our core businesses: search and advertising. – 2007 Founder Letter

4. Valuation

Stocks go up and down for many reasons. Even their earnings may go up or down for many reasons. As an investor what we should think about is earning power. As I wrote above, Google has an earning power of generating 30% pre-tax operating margins. On 2014 revenue of $66 billon its pre-tax operating income will come to $20 billion. Applying a 10% cost-of-capital, Google’s operating assets should be worth $200 billion ( $20 billion / 0.1). Also it has net financial assets of $59 billion. Adding this together, zero growth valuation for Google is $259 billion.

As of this writing it has a market capitalization of $388 billion. At this price, the market expects Google to grow its residual earnings around 4%. With a lot of growth still left in advertising both US and international, I believe that the stock is undervalued. On top of this, self driving cars, project loon, and several other little bets might become positive black swans. In future everything phones, cars, home appliances will connect to the internet. All these devices will be running on Android. The company is on the right track to capitalize all this. The chart given below compares intrinsic value per share with market price. I used pre-tax operating earnings per share to calculate the intrinsic value.


Mohnish Pabrai, a well known value investor, purchased shares of Google at an average price of $526 and the stock is currently selling at $569. As of this writing, I do not own any shares of Google.


19 thoughts on “Google

  1. Fabulous post Jana – i learn a lot from you. one thing you may want to mention is that google is the original pioneer of “free for customer; subsidized by ads” model which now in different variants (freemium, free + paid) is the driving logic behind facebook, linkedin, twitter etc. They still use this “pavlovian association” (making customers believe their service is free) by occupying an ever increasing share of the customer’s data and time spent on internet – with the result that their network effect is very strong – hence, their success with youtube, android, google now etc. Even if someone comes up with a 10 x better search, their learning curve will not have the benefit of the amount of data and insights that google has already figured out.

    • Thanks Varadha. I would be surprised if anyone can come close go Google in search.


  2. Loss of advertising marketshare and loss of pricing power (declining CPC) are both signs of a declining moat. google’s moat is in the search business and not in the advertising business. Companies like FB are far stronger in monetizing mobile than Google. And traffic is moving to mobile.

    • Chris,

      Yes declining CPC and loss of market share is a concern. But will the trend continue or reverse. I don’t know the answer. Have to see how the movie unfolds.


      • Note also that companies like Snapchat, Pinterest, etc are also advertising competitors who haven’t started monetizing in a big way.

        Long time ago, newspapers were franchise monopolies for advertising. Then TV stations came along; newspapers were still monopolies, not franchises but still good businesses. Then online came along; newspapers were still monopolies but no longer good businesses.

        What happened was that newer advertising channels came along and advertisers started spreading their dollars. All the while their core “moat” in news remained unchallenged. Today, newspapers have a monopolies on news(collectively) but not on advertising. (Yes, online has changed distribution but advertising declined not from competition with other papers but with other channels)

        Like news, search is a advertising channel.

      • Chris,

        I really loved your newspaper examples.

        IMHO, because of power law few companies will control the advertising market even on mobile. With Google having fantastic assets like youtube, I believe that they have a good chance of being one of the big guys. If that doesn’t materialize then it is going to have a hard time.


  3. Hi Vembu,

    Can you kindly share how u calculated Net Operating assets and Net Financial assets from the BS.Thanks

  4. Great in-depth analysis on google. While at current prices the company seems undervalued based off fundamentals, how likely is management to take proactive steps to close this gap? The company has $60bn+ in cash and is generating $20bn+ in operating cash flow a year but has yet to implement a modest buyback to offset dilution from stock-based compensation. While management pays itself $1 a year, the founders have split the stock to have non-voting shares to cement their control and allow them to issue more shares without fear of losing control.

    • Silver,

      I don’t know for sure if they will. Based on their actions in the last 10 years, I trust them. Let us see how this movie unfolds.


  5. Jana…Great Post…

    As you said some of the future project may turn out to be one more positive catalyst for the company.If we look out as per our requirement,you could understand that self driven cars could be a major game changer in the field of transportation,Same could go for the project loon.But at the current scenario also,Google still commands a large market share in the terms of search engine.New and old advertisers cannot undermine the existence of such a big platform.


  6. Hi Jana

    Long time reader of your blog. Thanks for this awesome blog. I cant imagine the time taken for thoughtfully putting your thoughts in such a lucid manner. I am learning a lot. God Bless.


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