Since my last article on Square (NYSE:SQ) on Nov. 25, 2019, SQ stock has risen just 9%. I wrote this article after the third-quarter earnings ending on Sept. 30, 2019, were released on Nov. 6, 2019, and I wrote then that SQ stock was not as good a buy as PayPal (NASDAQ:PYPL).
Basically, my argument was that although SQ has faster growth, its valuation and profitability were worse off than PYPL. I still believe that SQ is probably overvalued, as not much has changed since then.
Adjusted EBITDA Guidance and the Valuation of SQ Stock
The company’s guidance in its earnings report said that adjusted EBITDA for 2019 will likely be between $410 million and $415 million. Now, SQ stock’s enterprise value (EV) is $30.3 billion — based on my calculations. This would make the EV-EBITDA ratio nearly 67 times.
That is a very high ratio. For example, the same ratio for PYPL stock is only 40.9 times.
However, PYPL does not provide guidance for its EBITDA. I estimated its EBITDA by using the same EBITDA margin as its trailing 12 months (TTM) and applying it to these analysts’ expectations of 2020 sales.
Overall, my point is that SQ stock trades for twice the valuation measure as PYPL — and that is very rich indeed.
Square’s Expected Growth Doesn’t Justify the Premium Valuation of SQ Stock
Furthermore, the problem with this premium valuation for SQ stock is that the expected growth just doesn’t the premium valuation compared to PYPL stock.
For example, analysts estimate that 2020 sales will be only 27% higher than in 2019. That kind of growth is nothing too spectacular, and it doesn’t justify a valuation of around 67 times EV to EBITDA.
The only way this could possibly be reasonable would be to assume that growth continues at this rate for the next three to five years.
For example, if sales a Square grew by 27% for the next three years by the end of 2022, they would reach $9 billion. Then, using today’s EBITDA margin of 19%, the 2022 EBITDA would be 105% higher than 2019 — or $845 million.
Additionally, as SQ stock has an EV of $30.3 billion today — as I mentioned above — this puts it on a 2022 EV-to-EBITDA ratio of almost 36 times. That is just about equal to what PYPL stock is trading at today.
So as you can see, there is a lot of growth expectations already built into the SQ stock price.
Other Factors to Consider With SQ Stock
Investors should consider two main issues that I have highlighted before.
First, in a previous article on SQ stock, I pointed out that much of Square’s profitability — including its EBITDA measures — involve an addback of expenses called Stock-Based Compensation (SBC). I argued that since these are recurring expenses, they are real costs and should not be added back.
I believe this is still true. And by not adding them back to SQ stock’s profits, the EBITDA figures are much lower than otherwise.
One More Factor to Consider: Gross Payment Volume
Another factor that investors should consider is the company’s main revenue driver: the growth in its Gross Payment Volume (GPV). Square generates revenue by taking a fee on the total transactions or GPV that it processes. This is called the “Take Rate” on its GPV.
The Take Rate has generally stayed fairly stable, although it has inclined a bit over time with higher GPV volumes. However, the GPV growth rate is the single most important factor that determines Square’s net revenue.
You can see in the chart I have prepared below that the GPV growth rate has been slowing on a quarterly and year-over-year basis.
This shows that GPV has slowed to an average of 5.3% per quarter. But more importantly, the red line at the top shows that the year-over-year growth rate in GPV has slowed each quarter in the past 12 months — other than the slight increase during Q3 2020.
So, What Should Investors in SQ Stock Do?
Square will likely announce its earnings for the full year near the end of February 2020. This is a long time to wait, and it essentially means that most of Q1 will be in the bag at that time as well.
Therefore, it will be important to see what the company says about its EBITDA margins, the growth in its GPV and its outlook for the rest of the year.
If it appears that the growth rates in these factors are slowing on a year-over-year basis, then it will be hard to justify SQ stock’s present valuation.
Remember I showed that EBITDA will essentially have to double in three years to justify the present market value. If it looks like it will take longer than that, then expect the stock to tumble — and vice versa, of course.
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, which includes both dividend and buyback yields. In addition, subscribers a two-week free trial.