Roku (NASDAQ:ROKU) reported its third-quarter earnings on Nov. 8. The results look pretty good on a year-over-year basis, but not so much on a quarter-over-quarter basis. This is important because Roku trades at such a high premium. Investors are paying for past growth — not present achievements.
For example, Q3 revenue grew 50% year-over-year to $260.9 million. That’s great. The implication is that this super growth rate will continue.
But the problem is that sequential growth is slowing. Q2 revenue was $250.1 million. This means the third-quarter growth was just 4.3% quarter-over-quarter. On an annualized compounded basis that implies that one year from Q2, the revenue growth rate will be 18.4%.
Granted, there is a seasonal effect in the first and last quarters, where revenue increases sequentially in Q4 and decreases in Q1. This is why year-over-year measures are important for those quarters. But the Q2 and Q3 sequential growth numbers are a good thermometer of Roku’s underlying revenue growth.
Analysts are lowering their expectations as well. For example, analysts expect full-year 2019 revenue to reach just $1.1 billion. But this is just 10.7% higher than the past year’s revenue.
The implication is that huge growth in Roku’s revenues are over. The normalized growth rate will be in the 18%-25% range. This means that Roku is overvalued.
Roku Stock Looks Overvalued
Roku stock trades at an enterprise value-to-sales ratio of 14.1 times. This figure seems closer to a price-to-earnings ratio, not a revenue figure.
This overvaluation does not necessarily mean the Roku stock price is set for a big fall. Typically what happens with these types of momentum stocks is the company will grow into its valuation.
Roku stock’s enterprise value is $15.7 billion today. In three years, if revenue grows 20% annually, revenue will be $1.9 billion. At that point, if Roku stock does not rise for three years, the EV-to-revenue ratio will be just 8.3 times. This is 42% lower than today’s valuation, even though the stock will be flat over that time period.
Roku Stock Is Valued at Sky-High Levels
Roku does not make positive net income. So analysts use adjusted EBITDA as a cash flow measure. In Q3 Roku estimated that it would earn between $30 million and $40 million in adjusted EBITDA.
So that means its present EV-to-EBITDA ratio is 45 times. That is a sky-high valuation. Obviously, analysts and investors expect growth in EBITDA to move higher.
Let’s project that out. Right now the adjusted revenue margin is 3.5% ($35 million divided by $1.1 billion in expected 2019 revenue). Assuming margins double in three years, the adjusted revenue would be $133.7 million. That would put Roku stock’s EV-to-EBITDA ratio at just 11.8 times ($15.8 billion divided by $133 million). This is a reasonable valuation in three years.
But don’t forget that assumes that margins double, revenue increases 20% annually and Roku stock does not increase for three years. That’s right. This super-high valuation assumes no increase in the stock price.
What Should Investors Do?
I have simplified the numbers and put the growth story at Roku in perspective relative to its valuation. I have shown that even if everything works out well, Roku stock has already priced in all the best news.
Sometimes a growth stock reports exciting news that is hard to analyze. But, it is good to balance the high growth rates the company is reporting with its present valuation.
Investors will be looking to see if Roku stock can do better than the implied growth rates in its present valuation. If revenue grows more than 20% and adjusted EBITDA margins exceed the 3.5%-7% range over the next three years, Roku stock might have a chance of rising. Otherwise, it is likely to stay flat as the company grows into its present valuation.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks. Subscribers get a two-week free trial.
