Square

Square's (SQ - Get Report) year-to-date performance was been largely unimpressive. Despite significant volatility in its shares, thus far it has trailed the benchmark, with the S&P500 up 23% while Square is only up just 9%. Why?

Because the past several months has been marked by investors' wariness if getting involved in overvalued companies.

Square's Q3 2019 results show that its adjusted EBITDA is slowing rapidly; meanwhile, its stock rose 5% on Thursday, before dipping 3% on Friday. For now this stock is best avoided. Here's why:

Strong Underlying Potential

As a reminder, Square has successfully built and monetized two separate platforms, its Seller ecosystem and its Cash App.

Both platforms are not only highly disruptive but intuitive, too. What's more, both platforms have very strong network effects that continue to strengthen each other's competitive advantages.

For example, within the Seller ecosystem, having recently lowered the price of its hardware, Square Register and Square Terminal, weekly sales have increased by 30%.

Square's CEO Jack Dorsey who is also Twitter's (TWTR - Get Report) CEO, noted on Square's earnings call on Wednesday evening that sellers are coming to the platform for one product and feel happy and confident to adopt another of Square's products, such as getting a quick loan or using Square's Payroll.

Similar trends are happening on its Cash App, where individuals come onto the platform because a friend or employer uses the platform already and this makes it quick and easy to send and receive money.

Furthermore, arguably the biggest news coming out of Square this quarter is Square's Cash App which takes a lesson from bitcoin to fractionalize the buying and selling stocks. According to Dorsey, given that many stocks are so expensively priced, Cash App allows customers to buy and sell a fraction of stock.

Growth Rates Are Slowing

If 2017-2018 epitomized investors' insatiable appetite for strong revenue growth first, and valuation considerations second, 2019 has seen a firm reversal with investors firmly focused on valuation first and foremost.

Square's Q3 2019 reported a surprisingly strong adjusted EBITDA number, up 85% year-over-year. But as we can see in the graph below, Square's adjusted EBITDA figures continues to point to a marked slowdown.

Even on the back of such a strong Q3 EBITDA figure, this only marginally increased 2019 adjusted EBITDA figure from up 60% to 61%.

Valuation - No Margin Of Safety

For a supposedly asset-light, mobile payment system, Square actually makes very little in the way of tangible cash flows.

Investors are being asked to value at $25 billion a company that has over its trailing twelve months made less than $600 million. And this figure does not include any capital expenditure or even factor in Square's heavy stock-based compensation as a "cash" cost.

As the table shows, the whole sector trades at a high multiple, with many of Square's peers trading at an even higher premium, and Square's competitor Shopify (SHOP - Get Report) being demonstrably more expensive.

Having said that, just because there are other companies carrying even less margin of safety this does not automatically mean that Square is a bargain investment.

Square's Adjusted EBITDA figures are slowing at such a rapid pace that it should make investors think what sort of EBITDA growth rate will Square have in 2020, particularly considering that Q4 2019 adjusted revenue (excluding Caviar) is guided to just 37% growth year-over-year. Without sufficient revenue growth, Square's bottom line will obviously struggle to shine.

Is it really worthwhile paying more than 65x cash flows from operations while the company is projected to grow at less than 40%? I argue that it's not.

The Bottom Line

Paying up for a fast-growing enterprise is a dangerous affair that works well until it doesn't. Meanwhile, overpaying for a company with a slowing growth rate becomes a very sure way to permanently lose hard-earned savings.

With plenty of other safer investments, investors would do well to sidestep this stock before it's too late.