Skip to main content

Square: Avoid This Overvalued Stock

Square's nosebleed valuation leaves investors with no margin of safety.

Square  (SQ) - Get Free Report delivered a strong Q4 result on Wednesday after the close and investors were pushing its stock higher in Thursday's pre-market trading more than 6%. Although Square's 2020 guidance looks unimpressive, its Cash App segment delivered hugely positive surprises.

Nonetheless, it is very difficult to find any upside potential left given that these shares are already priced at 87x forward earnings

Investors would do well to avoid this stock and await cheaper prices to prevail. Here’s why:

Strong Report: Cash App Surprises to the Upside

Square’s Q4 2019 revenue, excluding the Caviar business which it sold, was up 46%.

Square has two reporting segments: Seller and Cash App. Square’s Seller segment is responsible for payment solutions and contributes approximately 72% to Square’s total revenue.

This segment is more mature but it is exposed to huge competition. Square increased the prices of its transactions and although Square notes that its customer retention rates have remained high, this segment was up 26% year-over-year, significantly below the growth of its Cash App segment.

The crown jewel from Square's report was its Cash App. Indeed, this is a highly compelling aspect of the story here. This segment continues to impress, posting a revenue growth rate of 147% year-over-year.

What’s more, Cash App benefits extensively from network effects. Specifically, as more users come to the platform, they invite their family, friends, and employees to the platform. Once on the platform, they are discovering different products and engaging with the platform longer.

Cash App’s noteworthy features include Bitcoin, the Cash Card, Boost (a discount rewards program) and fractional equity investing. In fact, as of Q4 2019, fractional investing has seen the fastest user production adoption since Cash App’s launch.

Do Profits Matter? Or Is It all About Guidance?

For as long as Square’s share price and revenues are rising, investors have no need to get overly anxious and question what sort of profit margins Square is likely to ultimately report. For now, the narrative is focused on investing for growth opportunities and taking market share.

Having said that, excluding Caviar, Square’s Q1 2020 guidance is pointing towards an increase of 44% year-over-year, but it is expected to finish 2020 with revenue growth rates of just 33%.

Even if we account for the potential of low guidance for the year in order to make beating consensus all that much more impressive, this still apparently points to a significant deceleration as the year progresses.

Valuation – No Margin of Safety

Even putting aside the question of the sustainability of Square’s revenue growth, we should still be mindful that Square’s top-end guided adjusted EPS figure is $0.94. So even assuming the high end of this range, this still values the stock at 87x forward earnings.

Furthermore, Square finished 2019 with an adjusted EPS figure of $0.80, thus its 2020 adjusted figure is pointing towards a lower than 18% growth rate -- again, in a best-case scenario.

Dissecting its bottom line EPS further, we can see that for 2019, more than 77% of its adjusted net income is stock-based compensation that is added back. 

Consequently, although Square’s 2020 guided GAAP EPS figures points to another unprofitable year, more concerning is that its total shares outstanding increased by 17% in 2019. Looking ahead, Square’s guidance notes a "modest increase" in the total number of shares outstanding in 2020. 

The Bottom Line

Square’s growth appears to be slowing down, while its valuation leaves investors with no margin of safety. Savvy investors would do well to avoid the alluring narrative of this overvalued stock.