Square Stock: Too High, Too Fast?

After swelling 3.2x off the March 23 bottom, Square’s stock (NYSE: SQ) looks fully valued based on its historic Price-to-Sales (P/S) multiples. Square’s stock rallied from $40 to an all-time high of almost $134 before settling at its current level around $125 – a sharp increase compared to the S&P, which moved around 40%. The stock is beating the overall markets by a margin, as investors are optimistic about its revenue growth – especially after the jump in direct deposit volume for its Cash App, led by stimulus payments. Notably, its stock has doubled from levels seen in late 2019.

While the company has seen steady revenue growth over recent years, its P/S multiple has decreased slightly. A key factor behind the trend is the change in its net income margin figure from -2.8% to 8% over the last two years, with the figure likely to fall for the current year due to higher reserves for transaction and loan losses. We believe the stock is unlikely to see a significant upside after the recent rally and the potential weakness from a recession driven by the Covid outbreak. Our interactive dashboard What Factors Drove 227% Change in Square Stock between 2017 and now? has the underlying numbers.

Some of this rise over the last 2 years is justified by the roughly 113% growth seen in Square’s revenues from 2017 to 2019, and it has been able to convert its losses of -$62.8 million in 2017 to a profit of $375.4 million in 2019.

Square’s P/S multiple changed from 6.0x in 2017 to 5.5x in 2019. While the company’s P/S is up to 11.5x now, there is a downside when the current P/S is compared to levels seen in the past years – P/S of 5.5x at the end of 2019 and 7.0x in late 2018.

So what’s the likely trigger and timing for further upside?

Square is a U.S-based financial services, merchant services aggregator, and mobile payment company. As a result of the coronavirus pandemic, businesses have suffered significant losses led by the closure of non-essential stores and lower customer demand. The company provides a bulk of its services to small and medium businesses (like restaurants and retailers), which have struggled the most in the current crisis. Also, it has a sizable portfolio of loans to small businesses under Square Capital loans, which are likely to come under stress due to growing loan defaults. On the positive side, though, Square’s consumer Cash App and Weebly web hosting service for e-commerce have generated good momentum over the last few months. Taking all this into account, we believe Square is unlikely to report sizable revenue growth figures for Q2.

However, over the coming weeks, we expect continued improvement in demand and subdued growth in the number of new COVID-19 cases in the U.S. to buoy market expectations. Following the Fed stimulus — which set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view. With investors focusing their attention on 2021 results, the current valuations need to be compared with historic valuations to find value in stocks. And while the rally in Square’s stock over recent months is understandable given its strong revenue growth potential, we believe the elevated P/S multiple represents a risk to the company’s valuation in the near term.

While Square’s stock presents limited upside potential, which S&P 500 component stocks are likely to outperform the benchmark index? Our 5 In the S&P 500 That’ll Beat The Index: TWTR, ISRG, NFLX, NOW, V look promising.

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