Better Buy: Shopify Inc vs. Square Inc

Most companies we hear about in the news are Goliaths -- worth hundreds of billions of dollars and vastly affecting society. The average investor could be forgiven for not realizing that small and medium-sized businesses are actually the bread-and-butter of the world economy.

As such, those that offer solutions to make life easier for such organizations have a huge opportunity on their hands. The two companies we're investigating today -- Shopify (SHOP 6.43%) and Square (SQ 0.22%) -- exist for that very purpose.

Image source: Getty Images

But which is the better buy today? That's a very difficult question to answer. Instead of giving a definitive judgment right off the bat, let's jump in and see how these two stack up on what I consider to be the most important metrics to evaluate before making a decision.

Sustainable competitive advantages

There's really nothing as important -- or difficult to measure -- for long-term investors than a company's sustainable competitive advantage. Often referred to as a "moat," such an advantage is the special something that keeps customers coming back for more, day after day and week after week, and holds the competition at bay for years.

Shopify's stated mission is "to make commerce better for everyone." The company's primary way of doing that is by providing a platform where vendors can handle their entire e-commerce presence. Shopify also focuses on ways to help solve payment and logistical problems, among other things.

The moat is created by sky-high switching costs. Smaller companies don't have the time or money to hire in-house experts to design a website. Employees are far better off focusing on how to provide the service or product that makes them unique.

Not only would switching to another e-commerce platform be expensive and time-consuming, but it would cause massive headaches. A company's website would likely be down for a period of time, there's no guarantee that the company wouldn't lose mission-critical customer data in the migration, and the company would have to retrain its staff on a new interface.

Square, on the other hand, provides a payment solution for organizations that aren't big enough -- or don't want to use -- the world's major credit card processors. Square charges a flat 2.9% fee, and your mobile device can instantly transform into a payment station.

The company is also offering ancillary services to build a bigger moat around itself, including invoices, instant deposits, and a wing dubbed Square Capital. The idea is that if customers not only use Square for processing payments, but also as a subscription service to collect data, switching costs will be higher.

Both companies have shown impressive growth rates, as evidenced by sales growth rates over the last two years.

Data source: SEC annual report filings.

But Shopify is the winner here, and it's not just because the company has been growing faster. The moat surrounding Shopify is demonstrably wider: Customers aren't willing to switch away, and bigger players have even given up their efforts to build e-commerce platforms that rival Shopify, and have instead decided to join forces.

Square, on the other hand, is primarily a payments processor. The competition here is fierce, and there's nothing to make switching costs all that high. While the company's efforts at providing invoices and instant payments is a step in the right direction, the moat is no where near as wide as Shopify's.

Winner = Shopify

Financial fortitude

Both of these companies are valued at roughly $6.5 billion. By stock market standards, that's small. And given that neither is profitable, they are still (hopefully) early in their lives as corporate entities.

While holding cash on the balance sheet seems like suicide when it could be reinvested back into growing the business, it's critical for any savvy company to do.

That's because all companies, at one time or another, will face a financial crisis. Those that enter these periods with cash have options: buy back shares, acquire rivals, or -- most importantly -- outspend rivals to gain long-term market share.

Those that are debt heavy -- especially when as small and unprofitable as these two -- can suffer a death-blow from such circumstances. Here's how the two stack up:

Data source: SEC filings, Yahoo! Finance.

Both of these companies are deceptively healthy for not turning a profit. Not only does absolutely no long-term debt exist between the two, but they aren't losing nearly as much money as it seems. Free cash flow losses are much more indicative of what's happening than net income losses, which can be massaged by accounting practices.

If we're looking for a tie-breaker here, it goes to Square, given that the company has a cash stash over 50% larger than Shopify.

Winner = Square

Valuation

Finally, we have valuation. Most of the time, there are a host of relevant data points to evaluate to determine which stock is the better buy. This time, that's not the case. Neither company is profitable, neither company is free cash flow positive, neither company has a PEG Ratio, and there's no dividend being offered between the two of them.

By almost all traditional metrics, these two are expensive. But which is more expensive, relative to their growth prospects, is much murkier. In the end, this is a draw.

Winner = Tie

Our winner is...

So there you have it... a draw. In situations like this, I always use the company with the stronger moat as the tie-breaker, so Shopify would come out ahead. That's exactly where my own money is as well: While I don't own shares of Square, Shopify occupies over 4% of my real-life portfolio.

I think investors interested in growth opportunities should investigate both companies, but it's clear which one I think is stronger.