Google's upcoming IPO has generated an avalanche of opinions about whether or not to invest. To me, the decision hinges on whether Google will be able to capitalize on a fundamental and powerful economic principle -- network externalities. Network externalities are the foundation for Microsoft's (NASDAQ:MSFT) business model in operating systems and for eBay's (NASDAQ:EBAY) business model in online auctions. The opportunity to own the standard due to network externalities is rare, and companies like eBay and Microsoft that are able to capitalize on such opportunities earn truly extraordinary economic returns.
Network externalities
The term "network externalities" is used by economists to describe when consumers benefit from other consumers using the same product or using the same standard. Network externalities come in two flavors: direct and indirect. Direct effects are cases like the telephone -- the more people that have a telephone, the more valuable owning a telephone becomes to any individual. There is a positive loop effect that drives continuously increased demand. Email has the same characteristics. In the early days of email, my mother resisted learning how to use it. But as all her family and friends began using it, the value to her of getting an email account increased, and she finally capitulated.
Indirect effects are based on the supply of complementary products. The classic example is VHS vs. Betamax. For a long time, you could buy either a VHS or Beta VCR at any electronics store. But as the popularity of VHS increased, the supply of complementary products (in this case, movies offered in VHS format vs. Beta format) drove the VHS to become the de facto standard.
Network externalities are virtually nonexistent in most industries. For example, if I like to drink Budweiser, as long as there is an adequate supply of it where I live, I do not benefit from others drinking it.
In most cases, such as the telephone or email, the government or an industry group sets the standard -- no single company owns the standard. However, in rare situations, the nature of network externalities in an industry gives individual companies the opportunity to own the standard. This allows them to gain a monopoly position, to act almost as a toll collector when anyone uses the standard, and to earn huge profits. The classic example is Microsoft in the PC operating systems market.
eBay's online auctions also clearly have strong network externalities. The more people who buy and sell on eBay's site, the more valuable it becomes for any potential buyer or seller to use the site. For most online auctions, eBay has already become the de facto standard. As a result, it is able to earn economic returns not typically found in a competitive industry. The market recognizes this, and eBay stock is currently trading at more than 20 times sales.
Implications and strategies in a standards war
In an industry where strong network externalities exist, a race to become the standard quickly takes place. The reason is because once a standard is set, it becomes very difficult to displace the incumbent -- the customer is locked in to a particular product. However, standards are typically set only after a tipping point is crossed -- a certain penetration in the market needs to be achieved.
Microsoft and Netscape raced head-to-head to set the standard for browsers. Netscape was the leader in the mid-1990s, with the better product and greater market share. But the browser market had not yet reached the tipping point, and through an aggressive strategy of bundling its browser with its operating system to extend the network externalities of the operating system, Microsoft was able to displace Netscape and win the browser war. Microsoft's browser, Internet Explorer, is today the de facto standard.
Network externalities in the search engine space
Network externalities clearly exist with search engines. The underlying logic of the search engine, including the hierarchy of how it lists websites in its results page, is likely to converge into one standard. People searching on the Web will become used to how results are arranged based on their searches, switching costs will increase, and increasingly customers will be locked in. At the same time, designers will optimize their Web pages around the standardized search logic so that their pages are prioritized in the results based on the keywords entered into the search. Finally, advertisers will pay more to have ads placed with the leading search engine technology, which will further reinforce the move toward standardization.
While I am confident that a standard will emerge for search engines, two key questions about Google and network externalities need to be addressed in the context of its valuation.
First, is there an opportunity for a single company to own the search engine standard? Or will the search logic be transparent enough to allow for all companies with search engines, including Yahoo! (NASDAQ:YHOO), Microsoft, and others, to provide search engines that use the standard search algorithms and results? If that is the case, a standard will emerge, but no single company will own it and be able to capitalize on it. The Internet search engine space will ultimately look more like the telephone industry than the PC operating systems industry.
Second, if there is an opportunity for a single company to own the standard, how likely is it that Google will be that company? Said another way, is Google's position today in the search engine world more analogous to Microsoft in the PC operating system space and eBay in Internet auctions or to Netscape in the browser market?
My opinion
In my opinion, the market is pricing Google's IPO assuming that the two questions above will be answered in Google's favor -- that a single company will own the standard for search engines and that Google will be that company.
I have serious doubts on both fronts. Unlike online auctions and PC operating systems, I think it will be much more difficult for a single company to own the standard for search engines. A very good case can be made that although Google has the lead today, sophisticated competitors like Yahoo! and Microsoft will likely be able to replicate and make incremental improvements to the logic and search algorithms that become the de facto standard for Internet search engines.
And if one company ultimately does control the search engine standard, in my opinion, that race is still wide open. The tipping point is still at least a few years away. As all users know, Google's technology is far from perfect. Its biggest advantage to date has been its objective approach to online searches. Unlike its competitors, the hierarchy of search results cannot be altered by buying a preferential listing in the results for a certain keyword search. Still, that advantage can be easily replicated, and there is still plenty of room for improvements in the underlying technology.
A scenario can certainly be painted where Google owns the standard in this space and earns the kind of economic returns implied in a $30 billion valuation. But the likelihood of that scenario playing out is not as high as many people seem to believe.
For more on Google today, Bill Mann tells you all you'll need to know about how the Dutch auction will work.
Fool contributor Salim Haji writes about stocks from his home in Denver, Colo. He does not own any of the stocks mentioned in this article. The Motley Fool is investors writing for investors.
