U.S. stock markets are hitting record highs, often led by so-called tech stocks like Google, Facebook, and Amazon, now valued at three to five times their 2008 prices.  In contrast to tech titans like Microsoft and Apple that produce and sell technology products, however, these companies earn their revenue largely through advertising.  Amazon, grouped in with tech companies, is more a logistics and payment services behemoth.

How long can this go on?

Google and Facebook earn almost all of their revenue through advertising.  They have continually upgraded their advertising technology through acquisitions and their own innovations, capturing an increasing share of the advertising market.

Both companies use their massive advertising dollars from Google Search, Gmail, Facebook, and Instagram to prop up various often unprofitable ventures.  Subsidizing across the company hasn’t negatively impacted their bottom lines, however, as reflected in their equity prices.

A business model that depends almost exclusively on advertising revenues begs the question of whether there are not overall limits to the size of the advertising market, and whether digital’s share of that market can continue to enjoy double-digit growth in what is historically at best a slow-growing market.  While traditional, or non-digital, advertising has stagnated since 2011, the overall advertising market has grown at only about 4.5 percent a year even with the geometric rise in the digital segment.

Testing the limits

In 2011, digital advertising accounted for 20 percent of all ad revenues, doubling that share by 2017.   Unless growth in the advertising sector itself accelerates, digital advertising—growing at about five times the pace of the total market—will soon dominate the market.  (Chart 1)

Chart 1: Growth in digital at current rates would overwhelm traditional advertising

As a practical matter, digital cannot completely replace traditional advertising through television, radio, and print, but under current rates of digital growth it will account for virtually all advertising by 2023.  Realistically, digital advertising will hit a cap, potentially when it controls two-thirds of the market.

Amazon, Microsoft, and others are currently making massive investments in advertising technology to compete in what is clearly a constrained digital market.  Some existing advertising-driven tech companies like Snapchat and Twitter, for example, are already struggling to succeed.

Assuming recent growth rates of 4.5 percent in total advertising continue and digital is limited in its expansion, digital formats could still account for a dominant share of all U.S. advertising by 2023, a market that makes up more than a third of the world total.1  However, this suggests a significant slowdown in digital’s growth, falling from an average of 17.5 percent in 2011-2016 to the high single digits by 2023.  (Chart 2)

Chart 2: Despite stagnating traditional advertising, digital will run out of room to expand before long

The long and short of it is that digital advertising is becoming more competitive at the same time that the upside opportunity is more limited.  Today, these stocks enjoy lofty P/E ratios, pointing to very high investor expectations for the future.  In our judgment, these expectations are likely to meet with disappointment.  The advertising market is often compared to smoke and mirrors and, in the case of digital advertising, eventually that’s what investors will be left with.