About a month ago, hyper-growth payment processing company Square Inc (NYSE:SQ) was riding secular growth trends in digital and mobile commerce to all-time highs. SQ stock had crossed $30 for the first time and showed no signs of giving up any momentum. I said investors should buy into that rally.
Blink once, and just like that, SQ stock is up 20% since then. The stock now trades around $36.
It’s safe to call this a break-out.
In fact, SQ stock has been in break-out mode for a while. A year ago, this was a $12 stock. It has essentially tripled since then. Such a big move higher begs the following question: How much higher can SQ stock go?
I think this stock is good for another 10% upside. Here’s why:
Square Is Attacking Big Markets
By now, the bull thesis on Square is well known.
Square finds itself on the right side of secular growth in digital (and specifically mobile) commerce. As phones have gone from communication devices to all-in-one personal assistants, they have also transformed into digital wallets and registers. Now, the entire payment transaction process can be completed with a phone and Square technology.
Thus, as more and more transactions go mobile, more and more payment volume will flow through Square. This trend is accelerating, and therefore, Square is positioned for big growth into the foreseeable future.
How big is that big growth? Really big. Payments processing is a $26 billion-and-growing market. But that $26 billion revenue opportunity isn’t even close to Square’s total addressable market. Square is plunging into markets which complement its core payments processing business. These markets include small-business loans (Square Capital and Square Financial Services) and food delivery (Caviar), among others.
All together, Square management believes the addressable market is around $60 billion.
Revenues this year are expected to be under $1 billion.
Big Growth Implies Higher Square Stock Price
Currently, Square’s huge multi-year growth potential is still being undervalued by the market.
Square is expected to grow earnings around 70% per year over the next 2 years. That growth rate will likely remain high for multiple years, given the massive addressable market, but the law of large numbers will pull growth down some. Given a 20-25% top-line growth rate over the next 5 years, plus huge margin expansion, I think it’s likely Square grows earnings around 60% per year over the next 5 years.
The S&P 500, meanwhile, is projected to experience super-charged 11% earnings growth over the next 2 years. That growth rate will assuredly come down in a forward 5-year window. Its likely the 5-year forward growth rate for the S&P 500 is about 7%.
The S&P 500 is trading at 19.6-times 2017 earnings for that 7% growth. That gives the market a price-to-earnings/growth (PEG) ratio of about 2.8.
If you apply that PEG to SQ stock, you get a “fair” P/E multiple of about 170. A 170-times multiple on 2017 earnings estimates of 24 cents per share implies a year-end price target of about $40. I have high conviction in this price target because: 1) earnings estimates this year are likely low given SQ’s ability to consistently top estimates, 2) Square’s growth potential in out-years is significantly higher than the S&P 500’s growth potential in out-years, and 3) the upward trend in SQ stock is very strong and is showing no signs of reversing.
Bottom Line on SQ Stock
I think SQ stock is good to the $40 level. At that point, unless something has dramatically changed about the long-term growth outlook, I think SQ stock will be fully valued.
Until then, I think sticking with the rally is the right move.
As of this writing, Luke Lango was long SQ.
