One of the most important things you can do while investing is to take your emotions out of it— just because you like a particular product or company doesn’t mean it’s a good investment. For me, that’s exactly the case with Shopify (NYSE:SHOP).
The company itself has a strong business model and I trust management’s future plans, but SHOP stock is simply too expensive to make it a worthwhile buy right now.
The Case for SHOP Stock
There are a lot of great reasons to want Shopify stock in your portfolio. The firm’s comprehensive merchant solutions platform makes it a top choice for small and mid-size retail businesses. Shopify has taken the friction out of e-commerce for small businesses and although it has plenty of competitors, the switching costs for merchants are relatively high. The financial and operational pain of transferring an e-commerce platform makes it harder for the small businesses that SHOP serves to consider alternatives.
Plus, SHOP stock has become an indirect play in several fast-growing industries. As my colleague David Moadel pointed out earlier this week, Shopify’s 6 River Systems acquisition makes Shopify stock an indirect bet on the cloud and robotics industry as well as an e-commerce play.
Perhaps even more enticing is Shopify’s entry into the growing American cannabis market. While the firm has been serving Canada’s marijuana market for some time, it recently announced plans to add on features that will support CBD merchants in the U.S. That’s a big deal as the CBD market is expected to explode in the coming years. Over the next five years analysts see the CBD market growing to be worth somewhere between $15 billion and $20 billion.
Good, Not Great
All of those reasons certainly back up SHOP stock’s growth potential, but you have to ask yourself if Shopify’s future growth potential is as compelling as its valuation suggests. Back in June I warned that SHOP’s valuation was too high and that the stock was likely to suffer a correction. Sure enough, SHOP declined more than 20% in September on news about a $603 million secondary share offering.
That’s because investors are jittery about hyped-up stocks like SHOP. Shopify is priced to perform above and beyond and that’s dangerous to buy into. The firm trades at 341 times its forward earnings—that’s head and shoulders above any of its competitors — stocks in the tech sector trade at an average of 21 times their forecasted earnings. Competing growth stocks like Etsy (NASDAQ:ETSY) and Wix.com (NASDAQ:WIX) have Price/Forward earnings ratios of 58 and 80 respectively.
That kind of sky-high valuation is setting SHOP stock up for failure. If the firm continues to outperform in the quarters to come, it shouldn’t move the needle much as that’s already baked into SHOP’s share price. However, a misstep of any kind could put Shopify stock into a tailspin.
While the firm is seen growing its business for years to come, Shopify is heavily exposed in the event of an economic downturn. Because Shopify serves mostly small businesses, the firm is reliant on favorable economic conditions to keep those businesses afloat. Small businesses have a high failure rate even at the best of times, add in a pullback in consumer spending or an economic downturn and SHOP may lose a huge percentage of its customers.
The Bottom Line on SHOP Stock
While I believe SHOP is overvalued at its current price, I’m keeping it at the top of my watchlist. Over the past few months we’ve seen several big names including Warrant Buffet start to stockpile cash in anticipation of a coming recession. Shopify would be a great name to buy in the event of a market meltdown because it would offer investors a better entry point into a solid business.
Shopify is a strong business with several promising future catalysts. However, investors are over-excited about the stock and that has driven the share price too high to make it a worthwhile bet. Staying on the sidelines until the share price falls to a more reasonable level looks like the best way to play SHOP stock right now.
As of this writing Laura Hoy did not hold a position in any of the aforementioned securities.