In the online advertising world, Google (NASDAQ:GOOGL) reigns supreme. With a dominant share of the U.S. search market, Google is the primary way of finding relevant information on the Internet. Bing, from Microsoft (NASDAQ:MSFT), is a distant second, posing no real threat to Google's dominance. Social networking company Facebook (NASDAQ:FB) has the potential to become a significant force in the advertising world, but Google has some big advantages.
Why Google's search ads work
When people are actively searching for information about a product or service, relevant advertisements prove very effective. If someone is searching for "car battery for 2012 Ford Focus" and an ad is shown for that specific battery, the conversion rate will tend to be quite high. Ads which aid in the purchasing process are inherently more effective than ads which are blasted to a more general audience. Display ads, for example, are largely ignored because the user isn't actively looking for information on the product.
Google is able to charge high prices for search ads because of the volume of searches that it processes every day. With a dominant share in the U.S. search market, there is no better place for advertisers to reach a large number of consumers. This influx of advertisers drives the price of ads up, since ads are bought on an auction system.
This has allowed Google to book massive profits. Last quarter, Google recorded nearly $3 billion of net income on $14.9 billion of revenue, a 20% net profit margin. The number of paid clicks increased by 26% year over year, more than making up for an 8% decline in the cost per click.
Unless there is a fundamental shift in the way people find information on the Internet, Google will remain the leader in online advertising.
There's room for two
The popularity of Google's search ads -- and the subsequent high prices -- have priced out many smaller businesses from using the platform. It's hard for a business with a $500-per-month advertising budget to compete with a business with a $10,000 per month budget in the same industry. The less popular Bing, however, offers a viable alternative.
Bing currently has an 18% share of the U.S. search market, well below Google's 67%. This means both far less search volume and far lower advertising costs. Because fewer advertisers are bidding on Bing's inventory, the same keywords could go for much lower prices on Bing compared to Google.
Of course, Microsoft would prefer higher volume and higher prices, but Bing provides search advertising for businesses which have been priced out of Google. There's certainly a market for lower-priced search advertising, and Bing fills this gap.
Bing isn't profitable for Microsoft, and it's been losing large amounts of money since its introduction. But revenue has been steadily growing, and losses have been getting smaller. Bing is important to Microsoft because without it, Google would control even more of the search market. Microsoft can afford to burn $1 billion per year on Bing if it prevents Google from becoming even more dominant.
The real threat
Facebook has the potential to be a disruptive force in the online advertising market. Ads actually appearing on Facebook will likely never be as effective as search advertising, but what Facebook does have is a tremendous amount of data. Advertisers can use this data to precisely target users based on their interests and serve them ads both inside and outside of Facebook.
Google has plenty of data as well, but Facebook, as the dominant social network, knows an awful lot about what its users like. The real question is whether these ads will be effective at generating sales. Recent trends are encouraging -- Facebook's click-through rate has risen dramatically over the past year. In July of 2012, the click-through rate was just 0.05%. Today, it's quadrupled. The average return on investment is also encouraging, with a recent report putting that number at 152%.
What this means is that Facebook is starting to become a legitimate advertising platform. Continued success could cause Google's average cost-per-click to continue to decline as advertising dollars are shifted to Facebook. There is plenty of potential, and the stock market is certainty optimistic, but with Facebook's market capitalization at nearly 40% of Google's, the optimism may be a bit out of hand. Google's revenue over the trailing 12 months is 9 times that of Facebook, and Google has profit margins which are well above average. Facebook can certainly grow quickly, but it's hard to justify its current valuation.
The bottom line
Search advertising works, and Google is the undisputed leader. It's unlikely that Google will give up this crown anytime soon, with Bing a likely permanent number two. Facebook has the potential to become a major force in online advertising, but the market seems to be assuming that this has already happened. The threat to Google is real, but Facebook has a long road ahead of it.
Timothy Green owns shares of Microsoft. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of Facebook, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.