Square (SQ -0.06%) is a fintech company that rose to prominence by creating a mobile credit card reader, allowing businesses to accept payments with a phone or tablet. Since then, the company has added adjacent services such as online bookings, business financing, payroll, and instant transfer of funds through its Cash App.
Square had its initial public offering in late 2015 and traded at approximately $12 for most of its first month. The stock began a meteoric rise in 2016, reaching an all-time high just short of $100 in September 2018. Shares have since calmed down due to uninspiring guidance, and Square is now trading around $64.
The company has been notching impressive growth figures, with a more than 25% expansion in payment volumes and 37% annual revenue growth. Investors are excited about future opportunities through Cash App, which is offering consumers opportunities to invest small amounts inexpensively in publicly traded equities and cryptocurrency. This is a highly competitive space, but leaders among young users have a clear advantage. Analysts are calling for between 25% and 30% annual expansion in the medium term.
Valuation ratios tell a mixed story
Investors must pay a substantial premium to gain access to Square's growth potential. The stock's price-to-sales ratio is 6.5, price-to-free-cash flow is 55.5, and EV/EBITDA is 252, all of which are high compared to the average financial payments or software stock. Square trades at a 69.4 price-to-forward-earnings ratio, and even the strong growth forecast is insufficient to drive a low PEG ratio, which is high at 2.57.
Investors certainly have opportunities to gain exposure to the payment and transfer market through other stocks. Paypal (PYPL 0.34%) trades at a much more modest 31.5 EV/EBITDA, 35.2 price-to-free-cash-flow, and 31.8 forward P/E. Even with less aggressive growth expectations, Paypal's PEG is still lower at 1.67.
Shopify (SHOP -1.81%) is another high flier that provides payment solutions to small businesses. Shopify is also in high-growth mode and is not returning profits yet, but its 31.2 price-to-sales ratio makes Square's valuation appear much more reasonable.
The competitive environment will get more crowded
Square operates in a competitive space as it stands, but the mid-term and long-term prospects could be severely jeopardized by more targeted competition by financial or tech giants. Alphabet, Facebook, and Apple have all developed payment and transfer applications, and Amazon has a payments solution for e-commerce. There is also an incentive for banks and financial institutions to integrate directly competing services. Any serious threat from one of these massive companies could create negative sentiment around Square, which is sufficient to cause rapid depreciation among stocks with strong valuations.
The inverse of this dynamic is meaningful as well, however. There is a reasonable chance that Square could be acquired by one of its potential competitors, especially if its installed base continues to proliferate and brand identity becomes even stronger. Industry peer Verifone was acquired earlier this year for $3.4 billion inclusive of net debt. Acquiring private equity firm, Francisco Partners, paid 1.9 price-to-sales and 17.6 times adjusted earnings, and Verifone's growth performance was well short of Square's performance and medium-term outlook. Square will fetch a more lucrative deal if a prospective competitor acquires it to enter the market without paying to develop this business internally.
Square's valuation will continue to be speculative, and it is hard to identify the current pricing as a clear opportunity for medium or long-term appreciation as a result. That said, there is clearly room for upside expansion based on multiples elsewhere in the market. If the company continues to deliver revenue growth alongside a move into profitability, investors are likely to react bullishly.