Square Looks Expensive. Is It a Buy?

With a whopping price-to-earnings (P/E) ratio of 219 as of Thursday's close, Square (SQ -1.97%) looks like one expensive investment. The stock hadn't moved much since late 2018, but effects from the pandemic have sent it skyrocketing 125% this year even as the company's net income fell back into negative territory.  

However, simply judging a stock using the P/E ratio doesn't tell the whole story and isn't the best way to value this company. It is undeniably expensive, but Square is expensive for good reason.

Image source: Getty Images.

Strong growth, rain or shine

Early in the year, as the global economy descended into recession, worry mounted that Square and other businesses that rely on consumer spending were in for some rough times. But while results thus far have been far from perfect, a combination of small businesses making a mass migration online to keep their operations rolling and government stimulus payments helped Square turn in far better results than expected. Revenue through the first half of 2020 is up 55% to $3.30 billion -- including a 64% advance in the spring quarter during the worst of the pandemic lockdown (or up 70% when excluding the now divested Caviar food delivery business).

Breaking down the revenue results reveals a diversified financial technology company with multiple outlets to continue its growth trajectory.

Data source: Square.

Cash App numbers were a particular standout during the second quarter, with active users now topping 30 million. Management said the mobile money movement and digital wallet app grew revenue 361% to $1.20 billion (or up 140% to $325 million excluding Bitcoin transactions) from a year ago. Consumer behavior was already changing quickly, but COVID-19 has given many households a sharp shove down the digital road. The use of a digital wallet to consolidate basic banking needs and movement of money into one place is fast on the rise.  

The big drag in the quarter was Square's flat transactions business (and related card reader hardware segment), based on merchant sales volumes. But as the economy slowly recovers from recession, those figures will rebound -- perhaps in dramatic fashion, as more small businesses and consumers alike are relying on electronic transactions like never before. And under the services umbrella, Square has plenty going on, like its credit division through Square Capital for its merchants and a new microloan pilot being tested on Cash App for consumers. There's also Bitcoin and stock investing on Cash App, including fractional share purchases. There's seemingly no shortage of growth possibilities for this big fintech outfit.  

Don't focus on P/E -- look at the relative size

With a market cap of nearly $64 billion as of this writing, Square is a large company, but not so big that its growth tank has run dry. After all, we live in the era of trillion-dollar market caps, and many of Square's peers fetch valuations in the hundreds of billions. But with such a high P/E ratio, at what point is this stock too expensive?

First, it's important to remember that part of the reason Square's price tag looks sky-high is that the company spends much of its available cash by design to promote growth. For example, "product development" and "sales and marketing" were 12% and 13% of total revenue, respectively, through the first half of 2020. That compares with 15% and 14% of revenue during the same period in 2019. If it needs to (like during recession), Square can back on these expenses to conserve some cash.

It's not going to back off too much, though. With a number of new services, Square needs to aggressively market itself to get enough new users to reach a more profitable scale. Case in point: Gross margin (revenue minus cost of service as a percentage of total revenue) fell to just 35% during the first half of 2020, compared to 40% last year. However, as Square and its Cash App subsidiary add users and activity on its platform rises, gross margin will increase as well.

And since profit is negligible at this juncture, something other than P/E ratio is needed to evaluate this stock. It's an imperfect metric, but the price-to-sales ratio (or P/S ratio, market cap divided by trailing-12-month revenue) can shed some light here. As of Thursday's close, Square trades for 10.6 times trailing 12-month revenue. This becomes a useful metric when comparing Square to its closest rival, PayPal Holdings, owner of digital wallet leader Venmo. PayPal has a P/S ratio of 11.6, a higher premium for a company growing more slowly than Square (although PayPal is highly profitable, which is to be expected for a more mature business).  

Nevertheless, viewed through this lens, Square doesn't look expensive at all. Sure, the bottom-line return just isn't there right now, but someday it will be. In the meantime, a premium is warranted for this fast-growing digital payments and money management stock. And Square trades for a fair price -- perhaps even at a slight discount -- when comparing it to its fintech peers. Put simply, don't let a ludicrous price-to-earnings ratio scare you away from a great growth story.