The Dow Jones Newswires report that Google will acquire On2 Technologies, a company that makes video compression, for $106.5M worth of stock, presumably for the video site YouTube.

It’s an awfully big investment - (a hefty 6.7x multiple of On2’s trailing twelve months (TTM) revenue, one of the highest multiples in tech over the last 18 months) - for a site which is perpetually the butt of jokes about not being able to turn a profit. But there are a number of reasons it might be a smart move.

At it’s core, Google has always been about using the power of computing to make information searchable and organized.  Video has a major limitation – unlike text, you cannot search by keyword, only by ‘tags’ – self-reported information – or by context, in this case, “links.” If 12 people link to a video with the word “Tango,” for example, then chances are the video is about tango in some shape or form. 

But Google is pretty good about finding ways around these limitations.  Google 411 was a free service that had a secondary function – it allowed for Google to improve its voice recognition algorithms to the point where it could offer Google Voice.  And if it can offer Google Voice, which automatically transcribes audio voicemail messages into searchable text, it’s not that much of a leap to transcribe the audio track of uploaded video into searchable messages.  That makes video more attractive to advertisers. 

Where On2 fits into this is that On2 offers a video codec, called VP6, which is compatible with Flash video and provides roughly the same quality as the current standard, H.264, at the same bitrates (filesizes).  However, the processing power needed to decode (play) the VP6 codec is significantly less than the processing power needed to decode the H.264 codec. 

Obviously, this is an advantage for Google, who is producing its own “Google OS” for use with low-powered netbooks.  Plus, there’s an awful lot of slow computers out there that are still in use. 

But less obviously – and this is a guess – because VP6 takes less processing power to decode, complex complications – like trying to do voice recognition – can be done faster when decoding thousands of VP6 files at once, compared to thousands of H.264 files at once.  Even if the difference is on the order of microseconds per video, when you’re talking about the millions of videos on YouTube, those little microseconds add up quickly. 

Perhaps Google is losing money, but it may be because they're creating, essentially, a new application, and trying to get the best performance for it before trying to market it, and increases in application performance can often offset hardware costs, power requirements, or bandwidth needs.