How Google's Garden Grows

Its stock rally is being fueled by increasing optimism that Google will finally succeed in branching beyond search-related ads

by Catherine Holahan

Those predictions that Google's stock would hit $600 aren't looking quite so outlandish any more. Not after a blockbuster third quarter and optimism that buying video downloading site YouTube will help Google conquer a whole new area of Internet search. The stock price has surged 11% in the past five days alone, closing at $473.31 on Oct. 24.

Still, there's reason to ask exactly what's driving the stock and how much further it has to go. After all, Google, valued at about $145 billion, dominates a market—online advertising—that will generate only $16 billion this year. Analysts at Standard & Poor's, which like BusinessWeek.com is owned by McGraw-Hill Cos., on Oct. 23 cut Google to "hold" from "buy," citing "potentially excessive enthusiasm regarding the company and stock" (see BusinessWeek.com, 10/23/06, "S&P Downgrades Shares of Google, AT&T").

Which Market?

The enthusiasm stems in part from a belief that Google (GOOG) will not only continue to grow its share of online advertising but also successfully expand into other, more lucrative markets such as e-commerce, which—excluding travel sites—is expected to pull in $104.9 billion in the U.S. this year, according to eMarketer.

When you take that into consideration, Google stock doesn't appear to have an immediate ceiling. Jefferies & Co. analyst Youssef Squali says the stock could reach $520 by yearend. "The question is really which market you think they [Google] are playing in," Squali says. "If you think that all they are doing is playing in the Internet search market and you define it very narrowly, in that case [Google] is way overvalued. But wait a second. These guys are moving into categories that traditional advertisers haven't really gone into."

Google already dominates online advertising, pulling in about 25% of all the ad dollars flowing onto the Web, according to an Oct. 16 eMarketer report. It has gained that considerable share primarily by serving up text ads next to searches and on its network of affiliated Web sites. Marianne Wolk, Susquehanna Financial Group's senior Internet analyst, estimates that Google controls about 70% of all the search advertising online. "Neither Microsoft (MSFT) nor Yahoo! (YHOO) is a major source of competition yet in search advertising," says Wolk.

Beyond the Core

And Google shows no signs of letting up. On Oct. 24, Google unveiled tools to allow users to build and customize their own search engines. In doing so, it moved onto the turf of companies such as Septet Systems, which offers the ability to personalize search engines and share them with others through its "Personal Search Syndication" site (www.pssdir.com). The company sells ads through Google and splits the revenue. "I'm very flattered that they are doing this, because it makes our business model that much more legitimate," says PSS's co-founder Benjamin Epstein, adding that his search engine still has some features Google's does not. "But, yeah, there is always concern that they will just wipe us out."

Competing for more search ad share, however, is just a part of Google's online advertising strategy. Google clearly plans to offer more branded and multimedia advertising. Its acquisition of YouTube provides a ready platform for video and multimedia advertising, and there is potential for it to serve up more than text ads through its partnership with News Corp.'s (NWS) MySpace.