Like many tech stocks recently, Square (NYSE:SQ) has seen its high-flying stock tumble. After breaching the $100 per share level in early October, SQ stock saw its price swoon. As a result, it now supports a share price in the low-$60 area.
Many prospective buyers may see this as a buying opportunity. However, with multiples remaining high, and the appetite for high-flying tech stocks waning, investors should probably continue to avoid SQ stock at these levels.
SQ Adds Value to Users, Shareholders
Once a decade, we see a financial tech startup that the tech giants cannot defeat. Intuit (NASDAQ:INTU) served as this company in the 1990s. In the 2000s, PayPal (NASDAQ:PYPL) became the online payment option of choice. The 2010s brought us the need to conduct credit card payments via the smartphone. Square came on the scene to serve that purpose.
PayPal helped make online payments possible. Still, Square’s technology takes most of the credit for making credit card acceptance possible for the smallest of enterprises. This has allowed Square to also offer products designed for larger businesses. Furthermore, it provided an independent platform. This allays fears that big e-commerce players such as Amazon (NASDAQ:AMZN) will also dominate payment systems.
Like the small businesses it serves, investors have taken to Square itself, particularly over the last two years. The stock soared so high that it attracted the “vision premium” — an outsized valuation inspired by involvement in a cutting-edge industry. This brought the price-to-earnings (PE) ratio of SQ stock to 200+.
However, stocks such as SQ that hold vision premiums have become the biggest victims of a stock sell-off that began in early October. As a result, SQ stock has fallen by almost 40% in the last seven weeks. While that merely brings SQ to levels seen in June, it also highlights how tenuous gains in Square stock have become.
Discounted SQ Stock Is No Bargain
The 40% discount will tempt many investors to take a position. Nonetheless, I would remain cautious. Despite the recent drop in the stock price, SQ still trades at about 135 times 2018 earnings. Analysts forecast 72 cents per share in profits in 2019. This represents a 56.5% increase from the 46 cents per share predicted for this year. However, this would still leave the forward PE at around 85.
Wall Street forecasts average annual profit growth for the next five years of 52.25%. For this reason, SQ deserves to trade well above the average S&P 500 multiple. Even though he pulls double duty running Twitter (NYSE:TWTR), I also believe CEO Jack Dorsey will help Square continue to revolutionize the payments industry. In time, it will match or possibly exceed the size of both Intuit and PayPal.
However, both Intuit and PayPal support substantially higher market caps on much lower multiples. In time, Square’s PE ratio will fall. While I expect SQ to become much larger, I think the stock price remains well ahead of the company’s growth.
Final Thoughts on SQ Stock
Although the Square stock price has seen a massive drop recently, investors should continue to avoid SQ. Square has offered huge benefits to the small business economy. Thanks to Square, debit and credit card services once available only to larger businesses have become available to everyone who owns a smartphone. This benefit has brought Square massive growth and SQ stock a triple-digit PE ratio.
However, even at a 40% discount, SQ remains a high-priced equity. Even if the stock remained at current levels, Square’s PE ratio comes close to the triple-digits even when compared to next year’s earnings. Its 50%+ annual growth rate deserves a premium valuation.
Still, in the future, SQ stock will likely resemble the equities of Intuit and PayPal. It will become a prosperous, large-cap company that supports PE ratios in the 40s. I would recommend Square stock at a high PE ratio — just not one as high as it sees now.
As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter at @HealyWriting.
