Roku (NASDAQ:ROKU) is trading at a sky-high valuation right now, but it could come crashing down if sales start to slow. That could happen if people start streaming less now that pandemic-related restrictions are over in many areas and will relax soon throughout the world. That means ROKU stock could fall to a more normal valuation for a fast-growing company.
Roku is up 260% in the past 12 months. However, year to date, ROKU stock is up just 20%. This is because the stock peaked out at $469.69 on Feb. 10 and has slid over 18% since then. As I suspected, the market is starting to realize that Roku’s valuation is probably extended.
Earnings and Valuation
Roku released its Q4 and 2020 earnings on Feb. 18 and reported that net revenue grew 58% year over year to $1.78 billion. The only problem is that the company still lost $17.5 million in net income over the year.
However, after adding back non-cash expenses and interest and taxes, the company produced $150 million in adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). In addition, Roku generated a good deal of free cash flow (FCF).
For example, the cash flow from operations was $148.2 million and capex spending was $82.4 million, producing FCF of $65.8 million. This also means that its FCF margin was 3.7%. I suspect over time that FCF margin will grow, given a huge operating leverage effect.
However, this FCF, compared to Roku’s $47.66 billion valuation represents an FCF yield of 1.38%. This is very high. The same high valuation relates to the company’s price-to-earnings multiples.
For example, analysts covered by Seeking Alpha forecast earnings per share (EPS) will be $2.37 by 2023 and $14.05 by 2025. This is why the stock has risen so much since investors are looking far into the future. The only issue is that we need to discount those earnings to their present value.
Using a 15% discount rate lowers the present value of 2023 earnings to $1.77 and the 2025 EPS falls to $5.87. That implies that at today’s price the price-to-earnings (P/E) ratio is 216 times for 2023 and 65 times for 2025 earnings. These are still very high ratios, despite the high growth rates in revenue and earnings over the next five years.
What To Do With ROKU Stock
If sales growth starts to slow over the next year, analysts will have to lower their expectations and earnings estimates. One reason this could occur is if more people spend less time than before in watching streaming TV as Covid-19 restrictions are lifted.
Another reason could be increased competition. Roku already has a very high market share. For example, Roku announced that 38% of all smart TVs sold in the U.S. were Roku TVs. How much higher can their market rise to?
Moreover, analysts are not projecting huge gains this year in ROKU stock like last year. For example, TipRanks.com reports that 20 analysts have an average target of $476.95. This represents a potential gain of 24.9% over today’s price.
However, Marketbeat.com reports that 26 analysts have written reports with an average target of $394.96. This represents a potential gain of 3% or so from today. In other words, these analysts believe that ROKU stock is at full value.
As such, given the stock’s sky-high valuation, most of the good news and future growth is already priced into the stock. Moreover, there may be fears, as I discussed, that its growth expectations could be in danger of flatlining.
Even if it doesn’t, value investors might be leery of committing new funds or even average cost buying into ROKU stock right now. They are waiting until there is some form of a bargain element. They may want to see the stock fall to gain a bit of a margin of safety before buying the stock.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.
