After trading as high as $29.80 last week, shares of Roku (NASDAQ:ROKU) have given back much of those gains. The stock is currently down about 10% today near $21.30 as of this writing. That's probably appropriate, as the valuation was looking a bit stretched at those highs, when shares were trading at over six times sales. With the pullback, shares are now trading around 4.6 times sales.

However, whether or not you consider that P/S metric lofty really depends on how you see the business evolving going forward. Roku has historically been a hardware-centric business, and that P/S multiple is extremely expensive for a hardware company. Many hardware companies trade around one to two times sales. If you think Roku will successfully grow its platform business and continue its transition to software and services, then a higher P/S multiple could be warranted due to the fundamentally higher-margin nature of software and services. With that in mind, it's worth digging deeper into the platform business.

Spoiler alert: It's really all about advertising.

Roku Channel on a TV

The Roku Channel will be free and ad-supported. Image source: Roku.

Ad revenue drives the platform business

For starters, here's a quick snapshot of Roku's two operating segments.

Segment

Revenue

Percentage of Total

Gross Margin

Player

$292.1 million

67%

13.2%

Platform

$144 million

33%

75.4%

Data source: Prospectus. All figures shown on a trailing-12-month basis.

Since platform revenue is so much more profitable, it accounted for 74% of gross profit over the past year, and Roku is strategically sacrificing player gross margin in order to grow active accounts. The company is also quick to point out that average revenue per user (ARPU) is soaring.

Chart showing Roku's ARPU rising over time

Data source: Prospectus. Chart by author.

It's worth pointing out here exactly how Roku defines and calculates ARPU: "[O]ur platform revenue during the preceding four fiscal quarters divided by the average of the number of active accounts at the end of that period and the end of the prior four fiscal quarters." Fair enough. Now investors need to see where exactly that platform revenue is coming from. Platform revenue is generated through revenue sharing of subscriptions and a la carte transactions (20%), or ad inventory sharing for free, ad-supported channels (30%).

It turns out that the vast majority of platform revenue comes from ads, according to Roku's prospectus (emphasis added): "In fiscal 2016 and the six months ended June 30, 2017, respectively, advertising revenue represented 63% and 67% of total platform revenue." In dollar terms, that translates into about $66 million and $55.2 million in ad revenue for fiscal 2016 and the first half of 2017, respectively. 

The advertising business is making progress

For any ad business, engagement and viewership is the key metric that advertisers look for. Total hours streamed is another operating metric that is posting strong gains, but not all of those hours are monetized through ads (many of those hours are not monetized at all). Roku streamed 6.7 billion hours of content in the first half, of which 2.9 billion hours (43%) included advertising.

Roku's future is very much predicated on its advertising business, which is why it launched The Roku Channel last month, which offers a large catalog of TV and movies that are free and monetized through advertising. Like all advertising businesses, Roku will need to hone and improve its targeting capabilities in order to deliver relevant ads, which is a function of user data collection. There are some secular tailwinds, like the ongoing shift of advertising budgets from traditional TV toward internet and streaming platforms, but Roku is a fairly small company compared to some of its rivals.

It's too early to say whether or not Roku's platform business will be successful, but investors are still pricing in high hopes for the transition, and they need to be fully aware just how much is riding on ads.

Evan Niu, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.