I’ll grant that there are plenty of reasons for optimism toward Coinbase (NYSE:COIN) stock.

The growth of cryptocurrency as a whole continues to impress. We’re nearing the point — if we haven’t already reached it — where it’s impossible to dismiss crypto as a fad or a bubble.

The increasing demand for crypto has driven impressive growth for Coinbase which, unlike so many growth stocks in this market, Coinbase already is profitable and impressively so.

But the story isn’t perfect. Some investors are figuring that out.

As I write this, COIN stock is rallying after four straight days of declines; it’s off about 12%. The weakness generally is ascribed to struggles in Bitcoin (CCC:BTC-USD).

There may be other factors at play, however. From here, COIN stock faces two key risks. The stock’s weakness may be a result of investors better understanding those long-term factors, rather than any short-term movements in the biggest cryptos.

The Case for COIN Stock

Coinbase’s 2020 performance is undoubtedly impressive.

According to figures from the prospectus filed ahead of this month’s direct listing, revenue rose 139% last year. Gross margins neared 90%.

In turn, net profits reversed from a small $30 million loss in 2019 to a stunning $322 million profit. Net margins were 25% of revenue — a figure that would be the envy of most companies in any industry.

A quick screen on finviz.com suggests that only about 10% of companies with a market capitalization above $2 billion have margins at that level, and some may have benefited from one-time factors that inflated reported profits.

Those numbers alone seemingly make COIN stock attractive. Its revenue growth is among the best in the market, matching or exceeding performance from some of the most dearly-valued stocks out there. Snowflake (NYSE:SNOW), for instance, “only” grew its FY2021 revenue 120%.

Yet Coinbase adds significant profitability to its top-line growth — and those margins should get better. The nature of a platform business is that incremental revenue turns into profit at high rates. It doesn’t cost Coinbase all that much to manage one more trade or pick up one more user.

COIN stock does trade at 169x 2020 earnings, which is a big multiple, but it’s not difficult to see why investors would be willing to pay up for this fundamental profile.

The Margin Question

There are two lurking risks, however.

The first is that the huge profit margins Coinbase is posting simply aren’t sustainable.

The problem here is that Coinbase’s fees are incredibly high. As I noted in a review of crypto exchanges this month, Coinbase charges a 1.49% fee simply for conversion of fiat to crypto. Other exchanges charge as little as 0.1%.

Over time, competition in any market usually brings prices down. That trend should be amplified in the exchange model, precisely because of the same incremental margins that drove Coinbase’s huge earnings growth in 2020.

If extra trades and extra users don’t cost much, rivals can price accordingly. The issue isn’t just crypto exchanges, many of which are located offshore and face greater worries about security and regulatory impact.

An analyst survey found that about 40% of Coinbase users also trade on Square (NYSE:SQ) or PayPal (NASDAQ:PYPL). Robinhood offers free crypto trading. Big banks and traditional equity brokerages likely will get in on the action as well; many are rolling out products for corporate and institutional customers.

Fee compression would dull Coinbase’s revenue growth. More importantly, it would significantly reduce the huge profit margins the company saw in 2020. If those margins are at a peak — and they may well be — it will take almost flawless top-line growth for COIN stock to grow into the current earnings multiple.

The Valuation Question

There’s another way to look at the valuation problem besides simply price-to-earnings.

Coinbase has a market capitalization of about $55 billion at the moment. Intercontinental Exchange (NYSE:ICE), which operates not just the New York Stock Exchange but bourses worldwide, is worth about $83 billion including debt. Nasdaq (NASDAQ:NDAQ) is worth about $29 billion on the same basis — barely half of Coinbase.

What would it take for COIN stock to, say, triple over a decade (about 12% annualized returns)? At that point, it would be worth $165 billion. Even assuming ICE and NDAQ stocks appreciate, at that point, Coinbase is probably worth as much as those two companies combined.

In other words, this single cryptocurrency exchange would be worth close to the entirety of the equity (and bond) exchange market. That’s a scenario that pretty much requires that cryptocurrency massively disrupts the financial world and that Coinbase is one of the big winners in the process.

That seems like a lot to ask. From here, it seems like too much.

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