Square Stock Isn’t That Attractive Anymore
Growth stocks have been big winners in this bull market for about a decade. But few have been as successful as digital payments processor Square (NYSE:SQ) over the past several years. Square went public at $9 per share in late November, 2015. Today Square stock changes hands for around $90 per share. That is a 1000% increase in just under three years.
Why the huge gains? SQ finds itself at the center of the cashless revolution. The company provides digital payment solutions which enable retailers of all shapes and sizes to accept non-cash payments. As the cashless revolution has gone mainstream and digital payments have become the norm, the amount of dollars processed through Square has skyrocketed. Moreover, the company is building a financial ecosystem centered on its payment processors. Among the components of this ecosystem are peer-to-peer financial transactions, small business loans, and a mobile payment network.
Put all that together, and the net result is robust revenue growth. When it comes to growth stocks, robust revenue growth usually leads to share price gains, and that is what we are seeing with SQ stock.
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Will this rally continue? In the near-term, yes. Square stock tracks Square’s revenue growth. Due to secular tailwinds in the digital payments world, the company’s revenue will likely continue to grow quickly. Thus, SQ stock will probably head higher.
But relying on revenue growth is a risky game. And, as it closes in on $100, the valuation of Square stock becomes harder and harder to justify, even if one accepts rosy growth assumptions. As a result, the risk-reward ratio of SQ stock is starting to skew towards the downside, and this might be a good time to consider taking some profits.
Why Square Stock Will Head Higher
Square is powered by the secular growth of simplified digital payment solutions. Square is at the heart of this transition and is enabling a new era of cashless, digital, and simple commerce that will become the norm in the foreseeable future.
Investors want exposure to this growth narrative, and SQ is the leader of the trend. The company’s revenues are rising by 60% annually, and its gross payment volume is increasing at least 30% each year. Moreover, SQ stock has continuously risen over the past several years.
Thus, when it comes to exposure to the growth of global digital payments, Square stock is first-in-class.
Investor demand for such exposure won’t drop meaningfully any time soon, considering the rapidly increasing popularity of digital systems. Furthermore, until Square’s top-line growth slows, Square stock will remain the best way for investors to gain quality exposure to this trend. Since Square’s revenue growth is actually accelerating due to the rapid growth of its services business, while its gross payment volume has constantly risen at least 30%, the company’s growth doesn’t look poised to slow any time soon
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Consequently, Square stock should remain investors’ top choice for quality exposure to the digital payments growth trend. As long as this remains the case, Square stock will head higher.
Why the Risk-Reward of Square Stock Is Growing Less Favorable
In a nutshell, Square stock will head higher because the stock tracks the company’s revenue growth, and the company’s revenue growth should remain huge for the foreseeable future.
While that thesis will probably play out, it is also risky. High-growth stocks that track revenue growth do so because investors assume that, eventually, profit growth will accelerate. If that doesn’t occur, high-growth stocks like Square could drop by large amounts. Considering there is no guarantee that SQ will ever have huge profit margins, and it has never had them in the past, long-term profit growth may not materialize. As a result, Square stock is rather risky.
Moreover, as Square stock closes in on $100, the valuation of the shares is exceedingly tough to justify.
Square’s addressable market is quite large. It includes all consumer spending globally, which was $28 trillion in 2010 and is expected to be $40 trillion by 2020. Granted, Square won’t be able to tap into a huge portion of that market because the company only deals with retail, food, and consumer-facing services. But Square doesn’t need a large slice of a $40 trillion market to justify a higher stock price.
SQ currently controls about 0.2% of global consumer spending. I think that figure can realistically grow to 1% over the next several years as Square’s machines and processing systems proliferate around the world. But that is only part of the company’s growth outlook. The other part is its suite of financial services, which include food delivery, a mobile payment network, small business loans, and peer-to-peer payments.
All things considered, I think Square could easily increase its revenue by 20%-30% per year over the next decade. During that stretch, its operating margins could soar towards 40%. But even in that scenario, an optimistic estimate of the company’s 2028 EPS is $6 per share. Two of its payment peers – PayPal (NASDAQ:PYPL) and Visa (NYSE:V) – have both historically traded around 25 times their forward earnings. A price-earnings multiple of 25 on EPS of $6 per share implies a long-term price target of about $150 for Square stock.
Since a 50% gain over a decade isn’t too impressive, the risk-reward on Square stock grows less and less favorable as the shares close in on $100.
Bottom Line on SQ Stock
Can the stock head higher in the near-term? Yes. But the shares could drop by a large amount if the company’s revenue growth slows,, while the potential reward in an “everything goes right” scenario isn’t all that big anymore. Thus, as this stock closes in on $100, I think it may be time to sell the shares.
As of this writing, Luke Lango was long PYPL and V.
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