It was a big pop and drop for shares of Etsy (NASDAQ:ETSY) over the past week. First, Etsy stock popped after the online retailer of handmade goods reported robust beat-and-raise third-quarter numbers. Then, Etsy stock dropped as markets tumbled and post-earnings enthusiasm dried up.

What’s next for Etsy stock? After the big pop, I warned a big drop was coming. Unfortunately, I don’t think that drop is over just yet.

Just below $50, valuation remains a tough pill to swallow for Etsy stock. In today’s markets where growth stocks are challenged by the reality of a bull market in its last innings, valuation will ultimately cap near- to medium-term upside in this name. Buyers here should proceed with caution, and understand that long-term fundamental upside is overshadowed by near- to medium-term valuation and sentiment risks. 

A Winning Formula Underpins Long-Term Upside

Etsy’s Q3 numbers affirmed one exceptionally bullish overarching theme for the company: Etsy’s growth fundamentals are improving at the same time that growth fundamentals at Amazon (NASDAQ:AMZN) e-commerce are deteriorating. This theme implies that Etsy has successfully fought off the Amazon threat, and is the unchallenged leader in the online handmade-retail space.

For a long time, the biggest knock against Etsy stock was that it doesn’t deserve its valuation because of inevitable “Amazonification”. Eventually, Amazon would copy exactly what Etsy does, and do it better. Sellers would quickly leave Etsy. Buyers would follow suit. The whole Etsy platform would collapse, and ETSY stock would drop.

That hasn’t happened.

Instead, Amazon’s e-commerce business has cooled. In particular, the company’s third-party services growth rate has cooled from 40% and up a few quarters ago, to 30% and slowing last quarter. Meanwhile, during that stretch, gross merchandise sales growth on Etsy has accelerated for five consecutive quarters, and registered at a multi-quarter high of over 20% in Q3.

This acceleration has happened despite Etsy upping its transaction rate during the process from 3.5% to 5%. Naturally, one would expect seller churn as a result of this rate hike. Instead, seller growth has maintained its high single-digit pace. Meanwhile, buyer growth has actually accelerated, and gross- merchandise-sales-per-active-buyer growth has gone from slightly negative to positive over the past year.

Broadly speaking, Etsy has affirmed its place as the unchallenged leader in the online handmade-retail space. This is a big market. Global spend on things like clothing, accessories, home, living, jewelry, and craft supplies measures $1.3 trillion. Etsy has just $3 billion in gross merchandise sales, and revenues are growing at a 30%-plus rate. Margins are depressed relative to long term potential, too.

As such, this company is supported by exceptionally robust long term growth drivers. In the long run, those growth drivers will propel Etsy stock higher. 

An Overextended Valuation Caps Near-Term Upside

Although long-term upside is compelling, near- to medium-term risks in Etsy stock are sizable and should not be ignored.

Revenue growth this year is running around 30%-plus. But, that is mostly because of the transaction rate increase. Long term, revenue growth will normalize back to GMS growth, which has run around 20% for the past few quarters.

After this year, revenue growth should normalize back to 20%. Assuming revenues hit $600 million this year, a 20% compounded annual growth rate thereafter implies fiscal 2023 revenues of roughly $1.5 billion. During that stretch, gross and EBITDA margins should continue to improve thanks to favorable pricing, heavier volume buying from consumers, and opex leverage. A 30% operating margin seems like a fair and reasonable target by fiscal 2023.

Under those fairly optimistic growth assumptions, I think EPS shakes out around $2.30 in fiscal 2023. That just isn’t enough earnings power to warrant a $50 price tag today. Even if you assume Etsy stock gets a huge-growth 30 forward multiple in five years, that implies a $69 price target by fiscal 2022 end. 

Discounted back by 10% per year, you are looking at a fiscal 2018 end price target of under $50.

More likely, Etsy stock gets an internet sector average 24 forward multiple in 5 years. Following the same calculus, that equates to a 2018 end price target of below $40.

Thus, prices near $50 for Etsy stock seem premature today. 

Bottom Line on ETSY Stock 

Long-term upside in Etsy stock is compelling. But, near- to medium-term risks are sizable due to a stretched valuation against the backdrop of a late stage bull market.

As such, buyers at these levels should proceed with caution.

As of this writing, Luke Lango was long AMZN.