Monday 7 December 2009

Online advertising can make money

"Get fat on Lorings Fat-ten-u and corpula...Image via Wikipedia

Business models involving online advertising are unlikely to get you VC funding these days. You're better off not having any idea where the money's going to come from than suggesting that advertising is going to turn you a decent profit.

A few years ago, you could walk into an investor's office and say "Google AdSense" and you'd receive a cheque in the post the next day. Nowadays, the sentiment is rather different. It's summarised rather well by John Naughton in the Observer yesterday:
Google is a special case because it specialises in search, the only area where online advertising really works. The explanation is obvious: people searching for something are likely to be deeply interested in the results, and are therefore more likely to click through to an advertiser. But in other situations – say when browsing web pages – advertising is peripheral and we have become very good at ignoring it.
Fortunately, this is completely wrong.

Google ads are sold on a CPC basis. That means the advertiser pays for clicks, rather than impressions (CPM), which is how most of the industry works. So Google only makes money when someone clicks on an ad. And that happens very rarely. In other words, John Naughton's explanation is totally wrong. The click-through rate (CTR) on Google ads is negligible. People very rarely click on Google ads.

So how can Google be making money?

1. Selling on a CPC basis is ingenious. It means the advertiser knows exactly how much it's going to cost to acquire a visitor to its site. It can then work out the cost of acquisition based on percentage of visitors converting etc. So the advertister bids up to a certain price for a keyword. Since the advertiser can set the maximum price to pay, many advertisers will be attracted to certain keywords, thereby preventing the price drifting too far down.It gets more complicated (not least with regards to page quality) but this will do as an overview.

2. When a media company serves up a page, it makes money from the advertising on it, at a much higher rate per impression than Google. Yet the media company produces far fewer impressions than Google AND the cost of producing a page is nearly zero for Google, while for the media company it requires the relatively costly 'creation of content' (journalists, editors, sub-editors...).

3. Google does not give away any of its revenue to another party. Strictly that's not accurate because it shares revenue with publishers on its content network but this is incremental gain for Google. Most publisher/advertiser deals include third parties such as ad sales houses, media buyer/planners and ad servers.

In a nutshell, Google makes money from advertising by selling almost infinite inventory at almost no cost, for a very low price.

In contrast, online media businesses have been losing money by having high overheads, diluting the value of their inventory by increasing the number of impressions, while trying to sustain a premium price. It's strategically inconsistent.

Can other publishers make money from ads online?

It's become trendy to talk about affiliate marketing, where the publisher has you click on a link to a retailer and if you buy, the affiliate (ie the publisher) takes a cut. You can make from this but you're unlikely to become a significant player. You're better off being an intermediary, like Skimlinks.

One solution is to create valuable content - to both users and advertisers - at the lowest possible cost; reduce inventory in order to create demand for scarce supply; insist on premium prices. It is possible to earn per impression 100 times more than Google.

For many publishers it's not going to be possible to do this because the overheads are too high. Investors may be ignoring the variability of the cost side of the equation. Can a music streaming business be profitable with ads? Almost certainly not. The licensing fees are far too high. Other media, however, might be able to overcome their costs.

Another possibility is to mimic Google and serve vast numbers of pages at close to zero cost and sell cheap advertising against it. Difficult to do, unless you're Wikipedia or some other vast site, like Facebook.

What about 'Freemium'? Well, that's just a way of saying, we'll make it free to attract the largest possible audience, (annoy them with ads) and hope that enough will pay for a subscription (without ads).

A final note

The curious thing about Naughton's article, which is all about Facebook, is that it's written towards the end of the year in which Facebook has begun turning positive free cash flow. How does Facebook make money? Vast numbers of nearly zero-cost pages, carrying low-price ads on a CPC basis. No surprise, then, that Google sees Facebook as a very real competitor.

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