How Risky Is Shopify Inc. (U.S.) Stock?

This article was updated on December 7, 2017. It was originally published on July 25, 2017.

The story is pretty amazing: Snowboarder tries to start his own snowboard company; when he tries to build an e-commerce presence, there are no options he likes, so he makes his own; over time, that business outshines the snowboards; eventually the company is taken public.

In a nutshell, that's what happened to Tobias Lutke, founder and CEO of Shopify (SHOP -0.36%). The company offers a subscription platform to help small and medium-sized businesses build sales channels across the Internet, as well as merchant services focused on payment and shipping solutions. Shares of the relatively young public company are up 400% since February 2016.

That has a lot of investors asking: How risky is this stock?

Image source: Getty Images.

Risk and volatility are two different things: The first represents the chances you could lock in serious losses of capital, while the second has more to do with short-term fluctuations. As you'll see, I define risk over four different axes, and only on the last is Shopify truly a "risky" stock.

How strong is the moat?

By far the most important thing to evaluate from the perspective of risk is the strength of a company's moat -- or its sustainable competitive advantage. In Shopify, I believe we have a company with a very strong moat, in the form of high switching costs.

Imagine you start your website using Shopify's platform, and slowly and steadily you build a presence that brings in money for you. Moving to a different provider would involve a hefty sum of cash, retraining employees on a new system, and potential downtime for your customers. It is also a minefield for the "unknown unknown" headaches. Considering all that, what would it take for you to switch over to a competing platform?

So far, Shopify's roster of clients has shown no signs of slowing down.

Shopify's Strong Moat
Infogram

Shopify is also the preferred platform for businesses trying to sell products on Facebook, Amazon.com, Pintrest, Twitter, and -- as of early 2017 -- eBay. Those are serious endorsements from some of the most powerful players in the world.

I don't see competition as a huge "risk" for investors at this point. And even though short-selling firm Citron Research claims that many of these newer merchants aren't legitimate businesses, I think the claims miss the mark.

Financial fortitude

The second risk worth investigating, especially for an unprofitable company like Shopify, is financial fortitude. The widest moat in the world won't matter if an economic downturn hits tomorrow and the company is forced to file for bankruptcy protection.

But after a recent stock offering, Shopify's balance, income, and cash flow sheets look very strong.

Data source: SEC filings. Net income and free cash flow presented on trailing-12-month basis.

While some might scoff that Shopify has "lost" $39 million over the past 12 months, I think it's a wise decision to continually spend slightly more than the company brings in.

Avoid Profitability & Grab Market ShareInfogram

That's because once the company is profitable, Wall Street will be clamoring for ever-higher figures. It's best for the company to grab as much market share as possible right now -- remember those high switching costs? -- and worry about profitability later. With over $900 million in cash on the books, Shopify can keep this trend going for a while.

Concentration risks

The third type of risk long-term investors should investigate is that which comes from relying on just a few customers for an outsize portion of sales. Referred to as "customer concentration risk," this situation makes a company fragile by putting itself at the whim of its clients -- where one unfavorable decision made one person at one company could doom investors.

While Shopify does have some big-name clients -- Tesla, Budweiser, and Red Bull  among them -- the chart from the first section shows that with over 300,000 clients, concentration risk is not a major concern.

Valuation risk

Finally, we have the one major risk that investors should be worried about: the stock's price.

Shopify's stock has doubled in 2017 alone. It currently has a market cap of almost $10 billion and trades for 17  times sales. To put that in perspective, Amazon -- itself still a growth story -- trades for 3.5 times sales. There are huge expectations baked into Shopify's stock, and if you can't stomach some gut-wrenching falls that can happen if the stock falls on the slightest whiff of unfavorable news -- like Citron's short piece -- this isn't an investment for you.

That said, I think that is a short-term concern. Many of the world's greatest companies were considered "overvalued" during their nascent stages. Those who didn't buy shares paid the price. Yes, the stock will probably be volatile, and that requires a strong stomach and a long-term time horizon.

But if you have those two things, I believe the risks associated with Shopify are less than you might think. And my own skin is in the game" The company accounts for over 6% of my real-life holdings. You might want to consider it for your portfolio as well.