The valuation of Square Inc (NYSE:SQ) makes no sense until you understand the business it’s in. Processors make very little money on each transaction, but they make up for it on volume. Best of all they get to hold the money for the hours or days they take to clear through banks.
This makes them a very good business. Square has added software and services aimed at the smallest businesses, accounting and even loans.
But its main advantages are that it’s easy for the smallest merchants to sign-up for, easy for them to use and understand, which also made it simple to build. It was among the first with readers that clipped to a smart phone and did business over cellular networks. But is SQ stock bordering on overbought?
Is SQ Stock Overvalued?
Square is the new kid on the processing block, having come to the public market in 2015 and having been founded just eight years ago, in 2009. This gives it a distinct advantage. It originally offered merchants just one deal, a discount of 2.75%, which made its processing job simpler.
To a casual observer, Square appears terribly overpriced. The company has never made money, its cash flow is miniscule. Its market cap of $6.6 billion represents more than three times last year’s sales of $1.7 billion.
But this is not out of line compared with peers: Vantiv Inc (NYSE:VNTV) is worth $12.84 billion on 2016 revenues of $3.578 billion. Visa Inc (NYSE:V), the industry’s dominant player, has a market cap of $211 billion on 2016 revenue of $15.082 billion. When Visa says jump, other processors ask how high.
Add the simplicity of Square’s back-end business model, along with the potential of its additional services, and it would seem investors are prepared to wait for a profit. The March quarter won’t be reported until May 3, and investors are expecting a loss of 6 cents per share on revenue of $448.51 million, compared with revenue of $379 million for the same quarter last year.
If Square is overpriced, in other words, then so is Visa, which has delivered 466% on investor money since coming to the market in 2008, along with regular dividends. And Visa is the Emma Watson of the current market — analysts can’t get enough of it.
While most analysts are optimistic about Square, with 17 of 28 having it on their buy lists, and no one having it at less than a hold, there are some who believe the sector is overvalued.
A commoditized and overpriced product, an overloved and overvalued stock, writes one, who thinks its fair value should be $2.10, against a present price of $17.58.
The idea is that Square mainly serves tiny merchants, that its niche has been discovered, and that it charges more than other processors. All that is true, but its additional services give it a moat with these customers, and there is the possibility of a takeover by a larger player.
Then there’s the CEO, whom you may have heard of. His name is Jack Dorsey, and he also runs another publicly-traded company, Twitter Inc (NYSE:TWTR), as hated by the current market as SQ stock is loved.
My View on SQ Stock
Square is an innovative player in a part of the market that is highly valued right now. Its valuation protects it from takeover, as it would represent significant dilution with any player other than Visa.
But if you want to be a pessimist, there is one processor that looks undervalued in this market. First Data Corp (NYSE:FDC) has a market cap of $14.52 billion on 2016 revenue of $11.584 billion. FDC is Square’s opposite in many ways. It has been in business for decades so its systems are ancient, and it’s loaded with debt, which management is working hard to pay off.
If you think the field is overvalued, buy FDC. If you think it needs innovation, buy SQ stock. But if you like good track records, buy Visa.
Dana Blankenhorn is a financial and technology journalist. He is the author of the political polemic Saving Trumpistan, Restoring Democracy, available now at the Amazon Kindle store. Write him at firstname.lastname@example.org or follow him on Twitter at @danablankenhorn. As of this writing he owned no shares in companies mentioned in this story.