Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Less than a week after Jefferies & Co. expressed doubts about the ability of Snap (NYSE:SNAP) to grow its business in an environment of "greater uncertainty around the global advertising picture," another analyst is weighing in with a somewhat more positive assessment of Snap. This morning, megabanker Citigroup announced it is removing its sell rating from Snap, and upgrading shares of the Snapchat owner to neutral instead.

Here's what you need to know.

Three panels showing group calling interface on Snapchat

Image source: Snap.

Five reasons to think Snap is worth $7

Like Jefferies did last week, Citigroup assigns Snap stock a $7 price target, as noted in a report today on StreetInsider.com (subscription required) -- about 10% more than what Snap trades for today. Citi cites five main reasons for its optimism:

  • Snapchat will be rolling out a new version of its app for Android phones, and Citi thinks the redesign could "improve user/engagement growth."
  • Average revenue per user (ARPU) growth accelerated in Q3 2018. The improvement was only modest -- up from 34% year-over-year growth in the first and second quarters of 2018, to 37% in Q3. Still, it was an improvement.
  • At the same time, Snap's spending has moderated in recent quarters, which should make profitability easier to come by if this trend continues in Q4 and beyond. Operating costs at Snap declined 11% in Q2 and fell 14% in Q3, according to data from S&P Global Market Intelligence.
  • Meanwhile, in contrast to Jefferies' generally downbeat assessment on the state of the online advertising market last week, Citi says it's hearing "generally optimistic comments from advertisers and agencies regarding [Snapchat's] platform outlook."

And here's the kicker: According to Citi, Snapchat stock now sells for a valuation that is "below that of Twitter and Facebook."

Say what?

That's obviously the comment I want to focus on today, because on the face of it, it's the one argument Citi makes that seems so blatantly wrong.

According to Citi, Snapchat's owner is a cheaper stock than either Twitter (NYSE:TWTR) or Facebook (NASDAQ:FB). And yet, both Twitter and Facebook are profitable companies. Each has reported both positive GAAP net income and positive free cash flow over the past 12 months. Snap, on the other hand, has neither net income nor free cash flow on which to base a valuation.

It would seem seem impossible, therefore, for Citi to claim Snap is valued "below" the valuations of Twitter and Facebook. (After all, if you don't have any E, it's very hard to have a P/E -- much less a cheaper P/E than Twitter or Facebook.) Therefore, Citi must be talking about some other kind of valuation here.

My guess: Citi is comparing Snap, Twitter, and Facebook based on their multiples to sales, rather than to earnings or free cash flow. And on this point, the analyst is right. At 7.6 times trailing sales, Snap stock does actually cost a bit less than Twitter (8.6 times sales) and Facebook (eight times sales).

A distinction without a difference

And yet, while Citigroup might be technically correct here, I'm not sure it should make much difference to investors. The purpose of a for-profit business, after all, isn't just to rack up a lot of sales -- but to earn profits on those sales. Unless and until Snap figures out a way to earn a profit from its business, therefore, it probably shouldn't make much difference to investors what price-to-sales ratio the company sells for.

Simply put: If it's not earning profits, Snap is not, in fact, cheaper than companies that are. That's why, if you ask me, investors are much better off considering a purchase of Facebook stock at less than 22 times earnings, or even Twitter stock at 24 times earnings, than Snap.

Check out the latest Snap earnings call transcript.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.