Is Google Too Generous?

Friday's announcement that Google (Nasdaq: GOOG  ) was doubling the storage capacity of its free email service to a full two gigs deserves some elaboration. I explained how this move was a clever way to trip up the marketing efforts of rivals Yahoo! (Nasdaq: YHOO  ) and Microsoft (Nasdaq: MSFT  ) as they look to upgrade their free email users to more lucrative premium offerings. But it's even bigger than that.

For starters, according to AccuStream, bandwidth costs fell by 19% last year. In other words, generosity comes cheap. However, to truly understand Google's strategy, we should learn more about how it stands to profit from Gmail.

Advertising makes up 98% of Google's revenue. That means the company has to grow by expanding its billable ad space. Using the same contextual paid-search technology that has "Ads by Google" wallpapering the Internet these days, Gmail is able to get the gist of the email and serve up relevant text ads in a column to the right of the message itself.

A few people blasted Gmail as an invasion of privacy when it was introduced last April, but most of those cries have ended, now that contextual advertising has become the lucrative Web standard.

And lest you think archived correspondence isn't all that valuable, think again. Google's ads are always current. So, let's say three years from now, you are revisiting a friend's email asking about movie times. The ads generated by Google would likely be tied to what's showing at the local multiplex in 2008. Wax nostalgic on that blur of a trip to Vegas with your buddies, and you will be hit with the latest lodging deals on the Strip.

Sure, email ads are going to have a low click-through rate. It's not the same as ads on other popular search portals like InfoSpace (Nasdaq: INSP  ) or Time Warner's (NYSE: TWX  ) AOL.com, where folks are there with the intention of being sent elsewhere. That's fine. Google is aiming for incremental ad revenue. Its lack of any email services to upsell -- like Yahoo! and Hotmail do -- means that it can focus on driving as much traffic as possible to serve up as many relevant ads as it can produce.

So why is Google so generous? The short answer: because it's greedy. Investors should just be grateful.

More of our recent thoughts on Google:

• Google's seeing double with the gigabytes, and that's a good thing.
• Yes, Google really did roll out its Gmail product a year ago.
• Not long after that, the critics came in hollering.

Longtime Fool contributor Rick Munarriz is a satisfied Google -- and Gmail -- user. However, he does not own shares in any of the companies mentioned in this story.The Fool has a disclosure policy. Rick is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.