How Google's Search Engine Makes Money

Google (GOOG) ranks number 4 in the world by market capitalization in the Financial Times Global 500, and more importantly, is the largest search engine in the world, with a market share of around 71%. After a mere 17 years in existence, what has made Google such a Goliath? The answer lies in its business model. Google offers an array of products and services including search tools, advertising services, communication, publishing, development and security tools, as well as map-related products, statistical and mobile-based software, hardware and cloud related services.

Most of the services it offers come with no direct monetary price tag to the average Joe. That requires a little digging to understand Google’s revenue streams. First and foremost, Google generates revenue from its advertising business, which consists of two complementary advertising programs, AdWords and AdSense, both of which charge advertisers based on the aggregate number of clicks their ads generate.

Advertising Revenues
AdWords is Google’s auction-based advertising program that inserts simple, text-based ads on the search-results pages of Google and its partner’s websites. Using the search terms, Google delivers relevant ads alongside with the search results.

AdSense is the program that Google offers to partners and other online publishers, who place Google AdWords ads on their own websites. Google also does brand advertising that promotes advertisers’ products and services through videos, text, images and interactive ads that run on distinct platforms such as TrueView (Google Business images) ads displayed on YouTube videos, Google maps, and other Google sites.

In 2014, the company generated approximately 90% of its revenues from advertising, with just over two thirds of that coming from from the ads on Google’s own websites. Revenues from Google’s websites grew at a whopping CAGR of 20% from 2012 to 2014. That increase can be attributed to the growing number of paid clicks, new ad formats, an increase in traffic on multi-device platforms and a continued expansion of the number of advertisers and users from developing countries. The average amount that Google can charge per click has decreased, however, driven by factors such as the diversifying geographic sources of the clicks, lower prices for mobile and tablet clicks, and the strengthening of the U.S. dollar.

Non-advertising revenues
Google also generates non-advertising revenue through products such as Google Play, which is an online store for apps, movies and music, Google for Work, Chromecast, as well as Nexus and Chrome OS devices. In 2014, company generated 11% of its revenues from this business line, up from 9% in 2013. The margins on these business, however, are volatile and may never equal those offered by its advertising business.

Geographical Segmentation
With respect to geographical segmentation, Google generated 43% of its revenue in the USA. International revenues have continued to increase over the years thanks to increases in multi-device internet penetration around the globe. That overseas expansion has exposed the company to foreign currency exchange risk. And last year, the strong dollar set up Google to take significant losses. In its 2014 Annual Report 2014, Google introduced a forex hedging policy that gives it wide latitude to address the issue.

Cost Structure
Google's costs break down into four major components: Cost of revenues, research and development, sales and marketing, and administrative expenses.

The company's cost of revenues includes Traffic Acquisition Costs (TAC), content acquisition costs, expenses associated with the operations of its data centers, and inventory costs for hardware, etc.

Google's TAC represented 67% of its total cost of revenues in 2014. It consists mostly of advertising revenues Google that shares with its network partners and distributors through the AdSense program. Those AdSense partners and online publishers receive 68% of the ad revenue hosted beside their content and 51% of the ad revenue for the searches on their sites. That's one reason the profit margins from AdSense program are lower than those for the AdWords ads on Google's own websites.

R&D expenditure includes the compensation for the company's massive R&D team of 20,832 employees, which represented 40% of the total headcount. With an increasing focus on R&D to further diversify its product offerings, that expense is expected to grow.

Google also has a huge sales and marketing team, with a headcount of 17,621. Its sales and marketing expense accounted for 12% of the company's overall expenses, and is expected to increase given the rising competition in the search engine business.

Recent Developments
Google has recently announced a major change in its corporate structure, where it will now have a new parent company: Alphabet Inc. The newly reorganized Google will be a wholly owned subsidiary of Alphabet Inc. The core operations discussed above will remain a part of new subsidiary Google. All existing shareholders of Google will receive one share of Alphabet Inc for every share they hold. Alphabet Inc aims to be a Conglomerate and will not only include operations of Google (advertising, search, emails and so on) but will also include other Google businesses such as Calico (anti-aging R&D), Nest (home automation), Fiber (broadband internet and cable television), investing arms such as Google Ventures and Google Capital, and projects such as Project X. Alphabet Inc will be run by Larry Page (CEO of old Google) and new Google will be headed by sundar pichai