Superior Online Advertising Platforms Enabled by the Internet Ecosystems of Google and Facebook

By Varun Gupta, CFA
July 2018

Online advertising is a form of advertising which uses the internet to deliver marketing messages to consumers. Today, online advertising consists primarily of advertising on search engines, social media applications, video-sharing websites, promotional advertisements, and banner ads. Online advertising is often referred to as digital advertising, while television, radio, and print advertising are considered traditional advertising.

In the past two decades, the online advertising industry has grown significantly, propelled by technological advances in internet access and the increased usage of mobile phones by consumers. For example, U.S. consumers use mobile and desktop computers approximately 47% of the time for media consumption.1 Advertisers follow consumers, shifting their budgets from traditional advertising platforms to digital advertising platforms, such as Google and Facebook. Thus, for the first time in 2017, global digital advertising sales exceeded television advertising sales.2

Diamond Hill currently owns two online advertising sector companies: Alphabet, Google’s parent company, and Facebook. We believe both companies benefit from the “ecosystem” of internet services they offer users. An internet ecosystem, inspired by natural ecosystems, can be thought of as an interdependent group of actors (users, content providers, advertisers, application software developers) who share or use internet services to achieve a mutually beneficial purpose. For example, a simplified view of Google’s search and online advertising ecosystem consists of:

  • Internet users searching for relevant information on their digital devices (mobile phones, desktops, voice assistants) amongst vast amounts of information available online.
  • Website content developers developing relevant information to answer user queries.
  • Advertisers trying to reach the right customers with relevant advertisements.
  • Application developers creating custom solutions to help both website content developers and advertisers manage their daily tasks in a more automated manner.

Google is the owner of this ecosystem and plays a central role in ensuring its success. They invest in technology, guidelines for advertisers and developers, and talent to ensure the best internet search experience to users for free. Google also helps advertisers reach target customers with relevant advertising and fight “bad actors” who cause security and advertising fraud issues.

We view Google as a collection of interconnected internet services which forms its ecosystem. Google has seven different internet services – Google Search, Android, Chrome, YouTube, Google Maps, Google Play and Gmail, each with more than a billion users.3 Apart from these services, Google also has Google Drive and Google Photos, which have more than 500 million users each. This combination of services strengthens Google’s competitive moat and reinforces a user’s habit of using the Google search engine as they seek information on the internet.

The power of Facebook’s services is realized when it is viewed and utilized as a rich social ecosystem that provides unparalleled opportunities for users to connect with each other using its four social media and messaging platforms – the original Facebook app, Instagram, Facebook Messenger and WhatsApp. Each of these services has more than a billion global users and benefit from network effects, a phenomenon where services gain additional value as more people use them. Both Google and Facebook monetize their ecosystem by offering online advertising services.

So, what makes an internet ecosystem an attractive asset? First, these ecosystems benefit from the “virtuous cycle of data” which increases Google’s and Facebook’s competitive moats. The best products naturally attract large user bases, who generate real time data through clicks, taps and “likes”, providing a feedback loop to Google and Facebook for rapid product improvement. This constant improvement of product features based on user data makes it hard for competitors to catch up as they do not have access to this real time data. Secondly, Google and Facebook’s large user bases entice advertisers into allocating more of their budget to ecosystems where they have the best potential of reaching their target audience. Lastly, ecosystem owners such as Google and Facebook have scale advantages, spreading large, fixed operations costs over a wide user base, leading to a high incremental profit business model.

Globally, users are increasingly spending a significant amount of time on smartphones, desktops, and voice assistants to access information and connect with other users. This shift in user behavior has unlocked new online advertising formats such as location enhanced ads, six-second video ads and dynamic ads, which can be constructed in real time based on a user’s search queries or interests, allowing advertisers to efficiently reach their target users at the right time and place. Google and Facebook have developed extensive self-serve advertising platforms to support businesses of all sizes. Historically, traditional advertising limited a business’ ability to efficiently advertise without significant initial investment and exposing themselves to potential business risks, such as missing their target audience or mistiming a message. Now, with the help of self-service online advertising platforms, advertisers can utilize their budget in a flexible manner. They can test different advertising messages at a low cost, using analytics to obtain real-time feedback on how these advertisements are performing and target a specific audience of potential customers. Since advertisers are directly managing their advertising campaigns, they can choose to increase, pause or decrease their advertising spend based on their business needs.

We also believe that technological advances in statistical data analysis and usage of machine learning on advertising process automation and delivery have just begun, and we expect these innovations to further benefit the online advertising industry in the future. While these techniques raise privacy concerns amongst users and regulators, Google has demonstrated that they are at the forefront of implementing innovative policies to help educate and protect users’ privacy on their platforms.4 We believe Facebook has taken several necessary steps to restore trust amongst its user base given the recent privacy issues, and we expect Facebook to manage these privacy concerns well without impairing the long-term value of their business.

As intrinsic value-based investors, we constantly monitor how a company’s competitive moat is evolving and the associated changes to our estimate of intrinsic value. For internet ecosystems, we evaluate the value of the current ecosystem, how permanent their ecosystem could be, and the potential threats to its success. We believe both Google and Facebook have built upon their initial success in web search and social networking, respectively, developing or acquiring additional ecosystems of internet services, further strengthening their moats. Past history indicates that internet ecosystems are susceptible to losing their competitive edge with changes in user behavior or expectations. These changes can be brought to users through new innovations from competitors or through technological advances. As long- term investors, we expect Google and Facebook to respond thoughtfully to competitors and lead these technological advances themselves, strengthening their superior internet ecosystems over time. For example, Google introduced its voice search application, Google Assistant, and voice search device, Google Home, to manage the competitive threat from Amazon’s voice search device, Alexa. Additionally, Facebook enabled its own version of short videos that users can post called “Stories” to compete with similar functionality from Snapchat. We have also seen Google and Facebook strengthen the value proposition they offer advertisers, ensuring they are supporting their goals of increased advertising efficiency, particularly compared to traditional advertising. We believe the combination of best internet services for users, providing best-in-class self-serve advertising platforms to advertisers, as well as other internet ecosystem benefits will position Google and Facebook well for the coming years. Additionally, we believe the current market price of both Alphabet and Facebook are trading at discounts to our estimates of intrinsic value and that both companies are attractive investment opportunities.

As of June 30, 2018, Diamond Hill owned shares of Alphabet, Inc. and Facebook, Inc.

1 Internet Trends 2018 (May 30, 2018) []
2 Magna Advertising Forecasts Winter Update (December 4, 2017) []
3 Google I/O 2017 Keynote presentation (May 17, 2017) []
4 Google Privacy Policies []

Originally published on July 24, 2018.

The views expressed are those of the research analyst as of July 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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