Shopify Is Still Not Cheap Enough for Value Investors

When I wrote about Shopify (NYSE:SHOP) last month on Oct. 21, I argued that its valuation was stretched out. Since then Shopify stock has fallen $103.71 or 10% to $918.30 on Nov. 13.

Shopify (SHOP) logo on an app on someone's smartphone.
Source: Jirapong Manustrong /

However, I still think that the stock is too high and most of its future good news is discounted in the price. There simply is no margin of safety for investors.

To make matters worse, though, I don’t know whether the stock will ever get into a buy range. This is because investors are still so ebullient on its prospects and are willing to pay up for this.

Shopify’s Valuation Issues

Here is the problem. The Ottawa-based company reported good earnings on Oct. 29 with $769.4 million in revenue or 96% over last year. However, the market values the stock at a huge multiple of that revenue.

For example, given that its market capitalization is $112 billion, this represents a value that is 36.4 times the run-rate revenue of $3.077 billion.

Moreover, analysts estimate revenue for 2020 will be $2.85 billion, and $3.74 billion in 2021. That puts the price-to-sales (P/S) ratio at 39 times (2020) and 29.9 times 2021 revenue.

To put it simply, these ratios are incredible and out of the park. These are the kind of multiples that most companies would love to have on their earnings, i.e. much lower numbers.

The Theory Behind Paying Up for Shopify Stock

Here is the theory of why the market believes this type of valuation works. For example, if revenue were to continue to rise 100% for the next five years, by the end of that period the revenue will be 32 times the present level. In other words, the revenue will be about $96 billion. That makes its $112 billion valuation look reasonable at about one times five year’s forward sales. The problem with that theory is that there is a huge leveraged discrepancy between compounding at 100% for five years and say at 50%. For example, if revenue grows only 50% on average annually going forward, it will be only 7.59 today’s revenue. That is a lot lower than 32 times.

That implies that the forward revenue in five years will be only $23 billion. This puts the $112 billion market cap for SHOP stock at five times forward revenue.

And if Shopify has just 30% average annual sales growth, in five years it will be just 3.71 times today’s sales, or $11.1 billion. This puts the stock on a high 10 times sales in five years.

Earnings Forecasts and Valuation

Right now SHOP is also selling at 249 times forecast 2020 earnings per share (EPS) and 274 times 2021 EPS. 2021 multiple is higher since analysts expect lower earnings in 2021. Nevertheless, you can see that these are sky-high multiples.

Once again here is the theory. Shopify made an adjusted net income of $140.8 million on $769 million in sales in Q3. That represents an 18% margin on sales.

Therefore, assuming a slight increase in the margin to say 20% in five years, the company will have adjusted net income of $4.6 billion. That assumes an average annual 50% growth in sales to $23 billion.

This puts today’s valuation of $112 billion at a future P/E of 24 times earnings in five years, assuming 50% growth in revenue. This makes the valuation today seem reasonable, but there are risks.

In other words, the theory is that growth will continue uninterrupted. Moreover, it assumes that Amazon (NASDAQ:AMZN) or Walmart (NYSE:WMT) won’t try to take away market share from the company.

But the problem is there is simply no margin of safety here. The growth outlook for 50% average annual growth in sales and a stable 20% net income margin must come to pass. Any hiccup will dent those valuation ratios quite harshly. You can see that in the way forward growth projections lead to exponentially higher multiples as higher growth occurs.

What to Do With SHOP Stock reports that 20 analysts have an average price of $1,161.17 for SHOP. That represents a 26% potential gain in the stock if it comes to pass.

However, says that the consensus target price of analysts is $1,026.59, or 11.9% higher.

The fact that these analysts believe the stock is still too low, shows that they likely assume higher revenue growth than 50% for each of the next 5 years. In other words, their projections going forward must assume much faster growth than this benchmark rate.

Therefore to invest in Shopify stock you must believe that the company will experience tremendously high growth on a consistent basis. You must also assume there will be no impediments to its growth, either from its own mistakes judging the market or from competitors.

That is a lot to assume. There will be no margin of safety at today’s price. For most value investors this is too much and the valuation still seems to have no bargain element. Better to look for a lower price to get in on Shopify stock.

On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.

Mark Hake runs the Total Yield Value Guide which you can review here.

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