After the recent market selloff, is Adobe (NASDAQ:ADBE) stock a great “buy the dip” situation? It depends. On one hand, the software giant has a deep economic moat. With its Document Cloud and Creative Cloud solutions, the company holds significant market power. On the other hand, investors know this full well. They’ve priced this into shares, which continue to trade at a rich valuation.
Adobe may be an established company. But with its strong growth trajectory, it’s far from being a mature business. With this in mind, a premium valuation is likely justified. Yet depending on your time horizon, shares may or may not be a buy at today’s prices.
Near term, don’t expect to see a big move higher like in 2019. Last year, shares soared nearly 50%, rising from around $220 per share up to $329.81 per share. With markets whipsawing, ADBE stock at best could tread water this year. If markets rebound, shares could appreciate. But don’t count on another 50% move.
Don’t take that to mean, sell Adobe shares, pronto! Far from it. Valuation may be rich, but the company’s growth prospects are on point. Let’s dive in and see why waiting for shares to go lower may be the best move.
Runway Remains Clear for ADBE Stock
With shares up nine-fold in the past decade, is there additional runway for Adobe stock? Signs point to yes. As InvestorPlace’s own Louis Navellier and the InvestorPlace Research Staff discussed Feb. 27, the company is not one to rest on its laurels. In other words, they could’ve easily milked PDF and Photoshop for cash flow, phoning it in with new versions of the software.
Instead, they are charging ahead, pivoting towards cloud-based SaaS (Software-as-a-Service) solutions. Like with Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT), Adobe is another opportunity for investors to ride the cloud and SaaS wave.
With this in mind, it’s perfectly reasonable that the company continues to deliver strong revenue growth. This bodes well for ADBE stock. Such continued growth helps to support its rich valuation. Yet, the easy money may already have been made. Similar to the impressive rally in Microsoft shares over the past year, the investment community likely has priced in the cloud catalyst.
What does this mean for investors looking at Adobe shares today? Shares could climb higher in the next 12 months. Just not as much as in recent years. Add in the risk of a valuation contraction, and investors should take heed before entering the stock at today’s prices.
Will Valuation Expand or Contract?
With a high market share and macro factors in its favor, it’s tempting to consider “buying the dip” with Adobe stock. And why not? Even in the recent market selloff, hot SaaS and cloud stocks haven’t exactly cratered. They’ve simply given up quick gains from the now-former runaway bull market.
It remains to be seen whether the 2020 correction will be akin to the one in 2018. If that’s the case, it makes perfect sense that ADBE stock could rebound to its 52-week high ($386.75). Perhaps it could move even higher, to the $400 per share price level and beyond.
On the other hand, what happens if we enter a bear market? Shares could give back more of their near-term gains and fall below $300 per share again. This is possible, considering the risk of valuation contraction. ADBE stock currently trades at a forward price-earnings (PE) ratio of 31.2. In comparison, Microsoft trades for 26.5-times forward earnings.
Assuming Adobe meets fiscal year 2019 (ending November 2019) earnings estimates of $9.81 per share, if valuation contracted to Microsoft’s forward multiple, the stock would fall to around $260 per share. In other words, that’s a potential decline of around 15% from the stock’s $305.79 close on Mar. 9.
Then again, Adobe’s upcoming earnings could surprise. The company’s guidance has called for revenue growth to fall below 20%. But, if the company crushes estimates, and demonstrates prior growth levels remain sustainable, fears of valuation contraction could go out the window.
Don’t Expect Big Moves Anytime Soon
Bottom line on ADBE stock: the underlying business is strong, but shares trade at a frothy valuation. The company’s growth prospects partly justify its high multiple. Yet if markets continue to trend lower, expect multiples to contract, not expand, in the near term.
Analyzing Adobe stock brings to mind this Warren Buffett quote: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
There’s no doubt Adobe is a “wonderful company.” But do shares trade at a “fair price?” That’s up for debate. If upcoming results show cooling growth, shares could fall to a more reasonable valuation. Considering this factor, a wait-and-see approach may be the best move.
Thomas Niel, contributor to InvestorPlace, has been writing single-stock analysis for web-based publications since 2016. As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities.
