Coming into 2020, payments processing giant Square (NYSE:SQ) was one of my top stock picks. Less than two months into the year, SQ stock is already up 30% year-to-date.
That’s a good thing. But it also forces some re-thinking as to what do with Square stock now. Is this huge rally an opportunity to take profits off the table on a red hot stock? Or is it the beginning of a much bigger breakout in SQ stock that will push shares back towards $100?
It’s a bit of both. Square stock presently trades north of $80. My numbers suggest that this is a fair value for the stock (i.e. shares are no longer undervalued).
Also, $80 has been a level of technical resistance for the stock over the past few years, and the stock has rushed into technically overbought territory. So on the heels of this big rally, caution is warranted; I can’t fault anyone for wanting to do some profit-taking here.
But as goes revenue growth trajectory, so goes Square stock. It increasingly appears as if SQ’s revenue growth trajectory will finally re-accelerate higher in 2020. If it does, this stock will ignore valuation friction, push through technical barriers and make its way towards $90, maybe even $100.
As such you have a bit of a mixed bag with this stock. This is a long-term winner that’s fully valued with enough operational momentum to support a rally into overvaluation. Given that, I say lock in some profits here, but keep a core position. Sell into strength if the stock rips back towards $100, but buy on weakness if shares pull back towards $70 or $60.
Square Stock is Fully Valued
There are several reasons to be cautious on SQ stock after its run up by 30% in less than two months.
First, the valuation is full. At 85-times forward earnings, this stock is very richly valued. To be sure, the valuation premium is warranted by robust long term growth potential in the cashless payments world. Still, even under fairly aggressive long term growth assumptions, my modeling suggests that Square’s long term profit growth potential warrants an $80 price tag on the stock today. Levels above that are less supported by fundamentals.
As such, with shares presently hovering north of $80, valuation friction is starting to become a problem.
Second, shares are running into technical resistance at $80, too. That is, since early 2019, this stock has staged three huge rallies (January 2019, June/July 2019, and January/February 2020). The two previous huge rallies in January 2019 and June/July 2019 were stopped around $80. It remains to be seen where this big rally will stop. But strong technical resistance at $80 is yet another risk which implies that the best of this rally may have already happened.
Third, the stock has sprinted into technically overbought territory, with its Relative Strength Index currently sitting above 70. This reading has sat above 70 for Square stock only a handful of times over the past three years. For the most part, whenever it has, Square stock formed a near-term peak.
The Full Valuation Might Not Matter
Although there are reasons to be cautious on Square stock up here above $80, there are also reasons to be bullish.
As I’ve pointed out before, Square stock trades with its revenue growth trajectory. When the revenue growth trajectory is accelerating (i.e. revenue growth rates are getting bigger every quarter), the stock roars higher. On the flip-side, when the revenue growth trajectory is decelerating, the stock struggles.
In 2020, it increasingly appears that Square’s revenue growth trajectory will start accelerating again, after two years of deceleration. That’s for a few reasons, including that the broader economic backdrop is improving, supported by increased liquidity, low rates, easing trade tensions, and strong labor market conditions. Also of note, Square’s new products (like Cash App and its online selling tools) are gaining momentum. Bigger growth at scale in these new products should help re-accelerate revenue growth.
Accelerated revenue growth in 2020 will give Square tremendous operational momentum. In this low rate environment, growth stocks with a ton of operational momentum tend to ignore valuation friction and head higher anyways.
As such, while I think it’s risky, there is definitely a viable pathway here for the stock to rip back towards $100 through revenue growth acceleration.
Bottom Line on SQ Stock
Square is a long term winner that should be included in any investor’s growth portfolio. That being said, while this was one of my top stock picks for 2020, I am now more cautious on the name given its 30% surge in less than two months. Can shares head higher from here? Yes. Will they? It’s uncertain, because the valuation is full.
As such, I think the game-plan here is simple. Sell some above $80. Keep a core position. See how the stock reacts to accelerating revenue growth next quarter. If it shoots up towards $90 or $100, sell into that strength. If it drops back towards $70 or $60, buy into that weakness.
As of this writing, Luke Lango was long SQ.
