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Square Stock Is Overvalued but Presents Buy-the-Dip Opportunities

During the last decade, fintech has been experiencing rapid global growth, and Square (NYSE:SQ) has been at the forefront of the revolution. To the delight of early investors, Square stock has shown phenomenal growth. The Square share price has skyrocketed about 650% since its November 2015 IPO.

However, over the past year, Square is up only 4%. In comparison, the S&P 500 index is up over 26%, hitting a new 52-week high on Jan. 13. And most of the up move in Square stock has come in the new year.

Now, as the earnings season approaches, shareholders are wondering whether Square will be able to make another significant leg up any time soon. I’d urge investors to exercise caution at current levels and consider taking some paper profits in the shares. If you do not currently hold shares in the company, you may regard any upcoming dip as an opportunity to go long the shares.

Earnings Expectations for Square Stock

When Square reports Q4 earnings in February, investors are likely to pay attention to growth rates. Its range of offerings include financial and merchant services, mobile payments platform as well as hardware such as point of sale (PoS) equipment.

As a result of the large ecosystem offered by Square, sellers, especially small merchants, are able to accept payments with a mobile device easily. Square’s mobile app “Cash App” also supports transactions such as payments or deposits with Bitcoin.

When Square reported Q3 results in November, its revenue came at $1.27 billion, a 44% increase YoY. Its adjusted EPS also increased over 90% YoY to 25 cents.

The company reports revenue in four main segments:

  • Transaction-based revenue (about 65% contribution);
  • Subscription and services-based revenue (about 22% contribution);
  • Hardware revenue (about 2% contribution);
  • Bitcoin revenue (about 11% contribution).

Transaction revenue consists of fees that sellers pays to Square to process their payment transactions, net of refunds.

Square’s subscription and services-based revenue is increasingly becoming a key catalyst for the company. Cash App, Square Capital, and Instant Deposit are the contributors to revenue.

Analysts also pay attention to Square’s quarterly gross payment volume (GPV), or the total amount spent through the company’s payment processing platform. In Q3, it had increased by 25% YoY to $28.2 billion.

However, in its quarterly reports, Square is known for delivering better-than-expected results only to issue weaker-than-expected guidance. And that tends to make SQ stock volatile with a downward bias, especially around earnings release dates.

Square’s Ecosystem Is Growing

In its early days, the company started out by addressing the needs of small businesses by offering a wide range of services that enable business owners to run their companies with more ease.

To the delight of investors, Q3 results showed that the company was also increasing the amount it’s making from larger and more lucrative sellers. The Street would like to see that this trend continues in the next earnings report. Omnichannel offering is crucial for attracting larger merchants to Square.

In 2018, the group purchased website-building company Weebly. Square is expected to increasingly integrate its eCommerce platform and payments processing with Weebly. Going forward, the move from brick-and-mortar merchants online merchants is likely to boost Square’s earnings. Shareholders would be quite encouraged by the growth of Shopify (NYSE:SHOP),the Canadian eCommerce software company.

The Street is also keeping an eye on Square’s lending business, Square Capital which provides loans to businesses. In Q3, it facilitated about 85,000 loans totaling $563 million, up 39% YoY.

Recent research led by Itay Goldstein of University of Pennsylvania highlights that in lending, “FinTech lenders process applications 20% faster… [For example,] as opposed to universal banks or specialized mortgage banks, [they] increased their market share of U.S. mortgage lending from 2% to 8% from 2010 to 2016.”

Therefore, we can expect Square to put more emphasis on its lending business.

And the Square Cash app which enables users to easily pay each other as well as businesses has become one of the most popular free cash apps. In Q3, total net revenue for Cash App was $307 million. Excluding bitcoin, Cash App revenue was $159 million, up 115% YoY. Soon, users will be able to rely on the app for investing and even buying fractional shares of stocks.

Rich Valuation Could Derail Square Stock

With a market cap of almost $30 billion, the payment company, headed by Twitter’s (NYSE:TWTR) CEO Jack Dorsey, is large and well-financed. The global payments industry is a $100 trillion-plus market, and developments in fintech are becoming the engine of change for so many businesses.

While Square has been enjoying a head start in serving especially small businesses and increasing its ecosystem, its stock price in 2019 has not reflected that growth. Let’s take a closer look at various metrics and see whether Square stock is overvalued.

Square’s forward P/E ratio is over 87. Compare with PayPal (NASDAQ:PYPL), and Fiserv (NASDAQ:FISV), two competitors. Their respective forward P/E ratios stand at about 36 and 29.

Similarly, Square’s current price-sales ratio is over 6.8. Analysts prefer a low P/S multiple, ideally below 1x. However, a P/S number between 1x and 2x is more common. To put the metric into perspective, the S&P 500’s average price-sales ratio is 2.3x.

Comparing various metrics indeed makes Square stock look rather expensive. Furthermore, it such high valuation level allows for now margin of error when it comes to quarterly earnings.

In early January Wolfe Research downgraded the stock to Peer Perform from Outperform with a $70 price target. Currently, SQ stock hovers around $68.

The Bottom Line on Square Stock

It would be fair to say that SQ is not finished growing in the long run and is likely to become a more dominant force in fintech in this new decade.

In the short-term, though, shareholders shouldn’t expect smooth sailing. I believe the markets are likely to be volatile in the coming weeks as companies release quarterly earnings. And like many momentum plays, Square stock will probably be a battleground between two camps: investors and traders.

Shopify is a momentum stock. Shopify can both act in a stock’s favor or derail its share price quite fast. I believe, for now, the stock is likely to trade in a range, between $60 and $70.

Unless management beats expectations and raises guidance in February, the current bullish momentum in SQ stock may not be able to last.

On the other hand, Square shares have strong technical support in the $57.5-$60 region. Therefore, investors may regard any fall in the share price towards these levels as opportune times to add the company to a long-term portfolio.

In the meantime, Square may well become a takeover target.

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