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Is Roku Stock Overvalued?

By Daniel Sparks – Sep 20, 2019 at 4:41PM

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Though it fell sharply on Friday, the video streaming platform specialist's stock is still up 250% year to date.

Shares of Roku (ROKU 1.22%) were slammed on Friday. At the close of trading, the stock was down about 19%. Roku's decline comes after Pivotal Research analyst Jeffrey Wlodarzak initiated coverage of the stock with a $60 12-month price target -- the lowest one on the Street for that company.

Shares have taken a huge beating this week, sliding 28% during the past three trading days. But even with that drop in the rear-view mirror, the stock is still up 250% year to date. Has Roku stock simply risen too high, too fast?

Let's take a look at some valuation metrics to see if the bears might be onto something.

The Roku Channel displayed on a TV

Image source: Roku.

A growth stock

It's easy to see why investors were so bullish on Roku for most of 2019. The company's revenue has been soaring. Even better, its revenue growth rate has been accelerating. For three quarters in a row, Roku's year-over-year revenue growth rate has climbed, culminating in the 59% growth it delivered in its most recently reported quarter.

In addition, the company's strong momentum prompted management to give a huge lift to its outlook for the full year. In its second-quarter report, management said it expects 2019 revenue of $1.075 billion to $1.095 billion, up from the previously forecast range of $1.03 billion to $1.05 billion.

That carried over to the outlook for the bottom line. Management now expects its net loss for the year to be between $61 million and $71 million, better than a previous expectation for a loss in the $65 million to $75 million range.

In sum, Roku displays the key characteristics of a growth stock -- and it's valued like one, too.

But is Roku worth $12.6 billion?

The big question, however, is whether Roku's underlying business can justify its current $12.6 billion market cap.

One certainly can't make a good case for that valuation based on its trailing-12-month net loss of $22 million.  But there is at least one metric by which it does make more sense: Roku's gross profit (revenue less cost of revenue) has skyrocketed. For the 12-month period ending June 30, gross profit was $406 million, up from $200 million in 2017 and $121 million in 2016.

If Roku can moderate its operating expense growth in the coming years and keep its gross profit rising on a slope similar to what it has been achieving, its bottom line could break into positive territory and surge higher. But investors will have to exercise some patience as they await that hoped-for outcome, because management's plan is to "reinvest incremental gross profit in our business to further strengthen our competitive advantages and growth drivers," according to the company's second-quarter shareholder letter. 

In short, while Roku's investments today may very well pay off in the form of more significant growth in gross profit in the coming years, Roku stock's $12.6 billion market cap is still highly speculative. In order for the company to live up to this valuation, gross profit will need to continue soaring and operating expense growth will have to slow substantially.

Though it's reasonable to expect gross profit to rise faster than operating expenses in the coming years as the company's investments begin to pay off, buying shares at this level simply requires too much faith. Roku stock could ultimately live up to investors' high expectations, but investors may want to wait for share prices to fall further before they buy.

Daniel Sparks has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Roku. The Motley Fool has a disclosure policy.

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