In this bull market, the path to investing success has been simple. Find a winner like The Trade Desk (NASDAQ:TTD) in an industry with secular growth, and hold on tight.
To be sure, that advice works in almost any market. But the bull market of the last few years has added a twist: ignore valuation.
After all, many of the market’s biggest winners have rallied despite valuation concerns. Tesla (NASDAQ:TSLA) never has been cheap, and in fact on a full-year unadjusted basis still has never been profitable.
Netflix (NASDAQ:NFLX) faced short sellers all the way from the teens to over $400. Roku (NASDAQ:ROKU) was perhaps 2019’s best stock based almost solely on revenue growth. Advanced Micro Devices (NASDAQ:AMD), particularly by chip stock standards, at times has looked “too expensive” as it has rallied over 2,000% from 2016 lows. Shopify (NYSE:SHOP) might be the market’s most dearly-valued large-cap stock and gets moreso seemingly every day.
Certainly, some growth stocks haven’t been so lucky. The batch of unprofitable 2019 initial public offerings led by Uber (NYSE:UBER), Lyft (NASDAQ:LYFT) and Slack (NYSE:WORK) has mostly stumbled out of the gate. AMD and Nvidia (NASDAQ:NVDA) fell hard in 2018. Cannabis stocks have imploded. Names like Square (NYSE:SQ) and Shake Shack (NYSE:SHAK) have struggled at times.
But even those negative examples are instructive. In pretty much every case, specific fears about the business — the bursting of the “crypto bubble” for chip stocks, the viability of the ride-sharing model for Uber and Lyft — or worries about the industry and/or competition (as with SQ and SHAK) — weigh on those stocks.
The Trade Desk, in contrast, is the clear-cut leader in a fast-growing industry. In this market, that’s been more than enough.
Is TTD Stock Too Expensive?
It’s certainly fair to wonder if TTD has run far enough, or even too far. Shares traded below $50 as recently as May 2018. A blowout first quarter report sent the stock up 43% on May 11; Trade Desk now has rallied over 500% in a little over 21 months. That includes 65% gains just since early October of last year.
And at these levels, traditional fundamental analysis suggests that valuation is a legitimate concern. TTD stock trades at almost 80x consensus earnings per share estimates for 2020.
That figure, on its face, doesn’t seem like that big a concern. After all, huge forward multiples are not uncommon in this market. To choose one example, Netflix trades at 63x 2020 consensus, with revenue growth expectations just above 20%. The Trade Desk’s top line should grow at least 30% in 2020. Other growth names, as noted earlier, aren’t even profitable.
Margins, however, are a factor worth considering. The Trade Desk’s guidance for 2019 includes EBITDA (earnings before interest, taxes, depreciation and amortization) margins of roughly 31.8% of revenue. Adjusted operating margins (earnings before interest and taxes) thus should come in over 25%.
Shopify, in contrast, is guiding for adjusted operating margins in the 2-3% range. And so that company actually has a much larger tailwind to earnings growth. If Shopify’s operating margins expand over time to 20% or higher, that alone will drive earnings growth of as much as 10x. The Trade Desk’s margins, however, are much closer to a ceiling; the company isn’t going to turn 75 cents of every revenue dollar into profit.
Indeed, Wall Street only expects EPS growth of 13% for TTD next year. Shopify’s bottom line should grow close to 400%.
Does Valuation Matter?
To be sure, it’s likely that Wall Street assumes that The Trade Desk will ramp investments behind its business in a bid to capture more market share and drive programmatic advertising growth. That’s a smart strategy, even if it negatively impacts 2020 profits. It’s one of the many reasons why investors can’t only look at the price-to-earnings multiple for TTD, or any stock, to determine whether a stock is “too expensive.”
But existing margins have to be taken into consideration. And they do suggest, from a purely fundamental standpoint, that TTD stock should receive some type of discount to other high-revenue growth names. The smaller runway for long-term margin expansion means a smaller runway for long-term earnings growth. And that’s what investors in this market are paying for.
The near-term question is: does it matter? And the answer over and over again has been: not really. I’m one of the many investors who argued Shopify stock was too expensive when it traded below $200. As of this writing, it’s headed for $500. Skeptics have decried valuations of many other high-growth, high-multiple names in recent years. Most simply have kept climbing.
To be fair, there’s some logic to these explosive gains. If a company is going to dominate a growing industry for decades, that business obviously has real value. And if interest rates are going to stay low for decades, as increasingly appears likely, then the second and third decades of domination simply are more important than they were in the past.
A dollar twenty years out is not worth much when investors can get 4% or 6% in “risk-free” Treasury bonds. Move that rate to less than 2%, and the dollar of profit in 2038 is substantially more valuable. In that environment, near-term valuation metrics still do matter, but they matter less than they used to.
As Long as the Market Holds…
The worry is that, at some point, these growth names simply will have run too far. And that point likely is getting closer when traditional value investors like myself are coming around to the idea that TTD can hit $400 or SHOP can double again in a matter of years.
And so TTD needs the market to stay roughly the way it is. Obviously, in a market at all-time highs, that’s true for most stocks. But the explosive gains in The Trade Desk, combined with a valuation that’s questionable at least based on traditional standards, leave a lot of room for downside if the “risk-on” trade in U.S. equities finally ends.
In the meantime, however, TTD is perfectly positioned. Digital advertising is going to grow for years. The shift to programmatic, which The Trade Desk’s own chief executive officer has called a “secular tailwind,” appears to be accelerating. And competition, at least in size and scale, is really nowhere to be found in the core offering (though Amazon (NASDAQ:AMZN) does loom).
Investors in this market mostly are buying the business, not necessarily the stock. And this is one of the best growth businesses out there, as I argued late last year. Until investor attitudes change, the trajectory of Trade Desk stock likely won’t.
As of this writing, Vince Martin has no positions in any securities mentioned.
