The One Equation That Matters For Search Companies

Includes: GOOG, TWX, YHOO
by: Mark Hines

In the world of search, there is one equation that matters. This formula drives revenue for every search engine that runs on a pay-per-click advertising model.:

Total Revenue = Total Search Volume * Ad Clicks Per Search * Revenue Per Click

An in depth analysis of each variable and the factors that impact them is a solid way to analyze search engines as businesses and investments.

Total Search Volume

Search volume, or the number of searches actually run on a search engine, dictates the number of ads actually served since ads are shown in search results, and revenue comes from ad clicks. Companies like ComScore, Compete, Alexa, and others produce daily, monthly and quarterly reports regarding search volume. Metrics are based on behavior of internet users that these companies monitor but quality and accuracy varies greatly.

 Search volume is in part dictated by the quality of the search results presented. An engine's algorithms determine content relevancy and the quality of results displayed, and an engine's index dictates the volume of information that the engine has "seen" and has available to display in results.Google, for one, has launched extensive efforts in the past couple of years to "acquire offline information". Some of their efforts, like Blog search, Scholar, News, Books, Product and Finance are directly in line with their search product, i.e. these efforts have increased the volume of content that Google can search and display when users are performing searches, which in theory should increase the quality of search results, keep users coming back to Google when running searches, and, over time, click more ads.

Other efforts like OpenSocial, the Open Handset Alliance, Orkut, Radio ads and the pending AdScape product and are less in line with search. These products will develop forum in which to display advertisements, the difference with former category being that these are products are generally unrelated to search and the ads displayed will not be in search results.

Ad Clicks Per Search

The rate at which ads are clicked per search, also known as click-through rate ("CTR") dictates the rate at which an engine is actually making money on searches. Paid search advertisements generally have massively higher CTRs than banner and in-text ads, mainly because people running for searches are actually looking for something and are trying to find the best thing to click. Targeted banner advertising is very hot right now, but at the end of the day, banner ads are banner ads.

Paid search CTR is in large part based on the quality of the advertisements shown to searchers. The initial PPC markets were strictly based on advertiser bids, meaning the ad placement depended strictly on the price an advertiser was willing to pay for a click. Google launched "Quality Score" a couple of years ago which started including factors like historical CTR into ad placement. This meant that an advertiser who was bidding less for a click could have their ad shown higher than someone willing to pay more if they had a better historical click through rate. The much delayed Yahoo! Panama project recently switched Yahoo! paid search ads to this type of system. It's generally accepted that the Quality Score type system works better than a straight market because it is the system used by Google, but it's possible that Google had good results simply because they have bigger and better inventory ad inventory than their competitors.

Revenue per click

Revenue per click, or price per click ("PPC") is the actual cost paid by an advertiser for a click. For example, an advertiser selling pencils might want his ad to be seen by people searching for "pencil". That advertiser can bid for ad positions within searches for "pencil" and the advertiser will then pay up to the amount of their bid when their ad is clicked. The price actually paid is based on the advertisers bid, the bids of other advertisers, and any and all other factors incorporated by the search engine. Engines that incorporate a black box Quality Score-type factor into their pricing can easily jigger prices and base increases on nebulous quality factors.

Also, since other advertisers' bids influence PPC, there is always potential for natural price inflation. No engine gives any transparency into prices paid for clicks.Products like Google Analytics and Google Checkout give Google insights into how much revenue paid search ads are sending an advertisers. Many advertisers have been reluctant to use these services for fear that Google will increase the costs of their ads. recently resigned with Google, so Google will continue to serve their paid search ads and get a big cut of Ask's revenue per click. AOL has a similar deal with Google, as does Fox/MySpace.

Thanks to Rob Webb, CEO of KnowledgeBid, for the help with this piece.