Square (SQ -0.39%) has had phenomenal success meeting the needs of small businesses that need a simple and cost-effective solution to accept digital payments at checkout. But after soaring more than 150% through September of this year, Square's stock price has cooled off a bit along with the recent sell-off in the broader market. 

We'll review Square's recent performance, risks, and valuation to determine if this is the right time to buy the stock.

A merchant helps a woman use Square's digital register at checkout in a store.


A winning strategy

Square's strategy is simple: Sign up merchants with hardware products, such as Square's card readers, and then upsell those merchants to stickier services, such as software that provides essential business management tools like payroll and invoicing. This strategy is delivering impressive results, with revenue up 51% year over year in the third quarter. Most of the company's revenue is derived from payment processing fees, where gross payment volume totaled $22.5 billion in the last quarter. That's an increase of 29% over the year ago quarter.

But selling card readers to merchants doesn't provide Square much of a competitive advantage since there's plenty of competing choices for point-of-sale solutions. That's why it's been so encouraging to see revenue from subscriptions and services grow at a triple-digit rate in recent quarters. 

Revenue from services, including business loans (Square Capital), Square's peer-to-peer payments app (Cash App), and Caviar (a digital ordering platform for restaurants) grew 117% year over year in the third quarter (excluding acquisitions) and made up 19% of total revenue.

Square has typically generated a loss on the bottom line, although it is generating positive free cash flow. Instead of worrying about showing a profit, management has been more focused on investing in new products and services to create more growth. The company has plenty to show for those investments: It just announced the new Square Terminal, and a new installment payment service that allows merchants to offer their customers financing options without relying on big banks. 

At this point, investors shouldn't be concerned by Square's lack of profitability. For one, services generate a much higher gross margin than payment processing fees. So as software services grow as a percentage of revenue, Square shouldn't have a problem generating a healthy profit margin over the long term. Additionally, the more services Square can offer, the tighter its relationship will be with merchants, which is key to building a sustainable competitive advantage.

Potential pitfalls

Those impressive top line numbers make it clear that merchants are finding Square's offerings very valuable, and it appears the company is definitely on its way to grabbing a piece of what management estimates is a $70 billion total addressable market across all of its services. But investors should be aware of a few challenges that Square will have to overcome to keep the good times rolling.

A fast-growing, lucrative market is not only attracting Square, but larger financial firms too, including Intuit and Capital One Financial, which have their own value propositions for merchants. Then there's PayPal Holdings which recently spent $2.2 billion to acquire iZettle, a point-of-sale solutions provider for small merchants across 11 international markets. 

As Square grows larger it will begin butting heads with these larger companies that have more resources and are already building trust and deep relationships with their own merchant partners. So far Square has proven it can adequately serve small merchants, but the uncertainty is whether it can successfully scale its services to meet the more complicated needs of larger businesses, in which a large financial firm like Capital One may be better equipped to serve.

CEO Jack Dorsey's long-term vision is to scale Square's offerings to serve businesses of all sizes, and so far the numbers look encouraging. The percentage of Square's payment volume coming from larger merchants has been trending higher, and now makes up 52% of gross payment volume. This shows that as merchants grow their businesses they seem to be sticking with Square.

Another risk to watch is the growth of Square Capital. Through this service, Square facilitated $405 million worth of loans in the third quarter, which represented growth of 34% year over year. Offering business loans is an excellent source of growth, and it helps build a very tight relationship between Square and merchants. But as this service grows larger it presents additional risk to Square, especially if another economic recession causes loan losses to spike and earnings to dip.

Is the stock a buy?

Square is having great success building its ecosystem of software tools, so I think the positives far out weigh the negatives right now. However, there are a few issues I have with the stock that keep me from calling it a buy.

First, there's Square's $29 billion market capitalization. That's already a third of PayPal's $99 billion market cap. But PayPal generates $15 billion in annual revenue and $3.4 billion in free cash flow, while Square generates only $2.4 billion in revenue and just $70 million in free cash flow. 

There's something out of proportion with that picture. At current prices, PayPal is worth three times more than Square, yet PayPal generates six times more revenue and 48 times more free cash flow. That makes Square's current market valuation appear inflated.

Square is growing its top line faster than PayPal, but even when we consider expected earnings growth PayPal is the better deal, trading at a price-to-earnings-growth (PEG) ratio of 1.88 compared to Square's PEG ratio of 3.06. 

I believe Square would be a good investment at a lower valuation, but for now I would wait for better prices before buying shares.