Are analysts missing the big picture on Google?

By Tony Arsta

After Google’s

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recent earnings release, much has been said about the decline in its cost-per-click (CPC) metric. This is understandable, since the 8% decline was far worse than expected. But I feel the focus on this one metric has been overdone, and many analysts are missing the larger, long-term picture.

If you don’t pay close attention to Google, you may not be familiar with CPC. There are two metrics that combine to make up search revenue: paid clicks and cost-per-click. Paid clicks represent the number of times that searchers click on a sponsored link. CPC is the amount that an advertiser pays to Google, on average, each time a paid click occurs. When it comes to revenue, both these items matter.

In Google’s most recent quarter, the 8% CPC decline was matched by a 34% gain in paid clicks — the net result was a 25% increase in revenue.

With the supply and demand curve of most businesses, lowering cost increases volume and vice versa. With Google, the supply and demand doesn’t work quite the same way since paid clicks are driven by the searchers and cost-per-click is driven by advertisers. But in general, it is common to see these two metrics move in opposite directions. That’s because advertisers in most cases set their budgets based on monthly or quarterly limits, so during periods with high paid clicks, the more aggressive advertisers blow through their budget and the remaining clicks are swept up by people willing to pay a bit less. On average then, the CPC declines as the paid clicks increase.

Also, note that CPC is an average for the company as a whole. Depending on the search terms in a given quarter, the mix can play a role in CPC. For example, according to Google AdWords’ traffic estimator, here are the CPC rates I could have paid recently to get the top ad spot for a few different terms, as well as the number of clicks per day Google estimates I would receive:

Mortgage refinance: CPC – $8.87; Est. daily clicks – 1,444
Mortgage: CPC – $6.33; Est. daily clicks – 4,160
Gold: CPC – $2.39; Est. daily clicks – 927
Acupuncture: CPC – $1.42; Est. daily clicks – 1,278
Accupuncture*: CPC – $1.53; Est. daily clicks – 93

* Yes, it costs more per click to appear in the misspelled results, although the number of paid clicks is expected to be far lower.

Other items obscure the CPC metric as well, such as foreign exchange rates and geographic mix (emerging markets pay less per click for example). And as Google reminded us during the conference call, CPC is lower for the fast-growing mobile market than for searches from a PC.

Where does Google have leverage?

The crucial question is how Google can impact these items. It all starts with the raw number of searches, so Google needs to work hard to keep searchers on its site. Much has been written recently about the threats of Facebook and Twitter, but Google is generating roughly 10% more searches than it was a year earlier in the U.S., according to comScore’s

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“explicit core search” metric. So searches have been growing well, and Google is still maintaining its market share.

Next is how many of these searchers click through to a paid link. Increasing this rate is a combination of art and science. Google is constantly trying to drive more people to the paid clicks without harming the overall experience. As you can imagine, this is largely insensitive to the economy, since the searcher doesn’t pay directly for the click.

Finally, there’s cost-per-click. In my opinion, the reason so many analysts focus on this is because it has ramifications far beyond Google. Yes, Google’s revenue is directly impacted by this number. But equally important to many analysts, CPC shows the appetite of the aggregate Google advertiser (which covers a lot of ground). If CPC is declining, that probably means that overall advertising budgets are in decline, since Google is such an overwhelmingly dominant part of the industry.

I’ve already discussed some of the variables that can impact CPC, such as foreign exchange rates and the growth of mobile search. But the bottom line for each of Google’s customers is that the return on investment for each paid click remains strong; until I see evidence that advertisers are not getting a decent ROI from Google, I am not concerned.

In reality, I pay very little attention to Google’s CPC. When the economy is struggling, the number goes down. When the economy is doing better and advertising budgets increase, the metric goes back up. None of this is particularly interesting to me on a quarter-to-quarter basis, since being able to nail Google’s quarterly results doesn’t do much to move my estimate of intrinsic value.

I would be more worried if a declining CPC could be shown to mean that Google was facing competitive pressures. For example, if Yahoo!

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or Microsoft’s

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Bing were taking a greater share of the paid clicks, or if advertisers felt that Facebook was a better value proposition than Google. But I have seen absolutely nothing to correlate the CPC with the competition – it seems to be entirely driven by macro concerns and product mix, as I discussed above.

One final note: Google doesn’t manage to CPC. The goal of its ad team is to increase revenue, and the goal of the company is to increase long-term value. Many of the levers it’s pulling have the specific intent to raise paid clicks, which may harm CPC over the short term while everybody ultimately benefits.

Yes, CPC matters. But not nearly enough to cause this much consternation.

AUTHOR DISCLOSURE: Motley Fool Asset Management owns shares of Google.

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