Please ensure Javascript is enabled for purposes of website accessibility

Here's My Top Stock to Buy in May

By Daniel Sparks - Updated May 21, 2020 at 8:26AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

This growth stock is worth its premium price tag.

During market downturns like the recent coronavirus market crash, it's tempting for investors to spend most of their efforts sifting through beaten-down stocks in search of bargains. But investors shouldn't overlook high-quality companies that have managed to impress during these times. There are times in which quality is worth its steep price tag. This is the case for Square (SQ -0.88%) -- a point-of-sale and financial technology company whose revenue growth has soared in recent years.

Here's a closer look at why this growth stock is worth its premium price.

A dollar sign with an arrow pointing to the right

Image source: Getty Images.

Rapid growth

Square has consistently grown at rapid rates. In its most recently reported quarter, revenue rose 44% year over year to $1.38 billion. However, for a more accurate look at underlying business growth, investors can exclude sales from food-delivery platform Caviar in the year-ago quarter since Square recently sold that business unit to DoorDash. This adjustment translates to 51% growth in the company's revenue -- an acceleration from 46% and 45% adjusted growth in the fourth and third quarters of 2019, respectively.

Square's strong top-line momentum recently has been driven by a combination of growth from its gross payment volume across its point-of-sale solutions and from services it provides to sellers.

Square's competitive edge

But strong business growth isn't valuable to investors unless it can be sustained over the long haul. Fortunately, Square has a strong competitive advantage in the form of a flywheel of products that serve sellers from many different touchpoints, including point of sale (hardware and software), working capital loans, payroll, menu management, third-party software integration, online stores, and more.

A restaurant employee interacts with Square for Restaurants platform

Square's platform for restaurants. Image source: Square.

Of course, Square's business model isn't exempt from the headwinds generated by COVID-19. During the last two weeks of the tech company's first quarter, gross payment volume across its platform was down 39% year over year. But the company's broad base of services helped offset some of this pain. Revenue from its subscription and services-based offerings was still growing toward the end of the quarter, albeit at a decelerated rate. Further, online transactions across its platform were largely unaffected by COVID-19.

More importantly, Square saw a surge of interest in its products as companies turned to Square's platform to help them adapt. Indeed, early data on the sellers onboarding to the company's services since COVID-19 sent the economy reeling shows that they are, on average, larger on both a transaction volume and a gross-profit basis than seller sign-ups earlier in the year.

While COVID-19 will take a toll on Square's revenue growth in the near term, many of the company's services have notably become more mission-critical than ever. Square's suite of seller services combined with its point-of-sale offerings will position it well to gain market share from sellers as they adapt to these unusual times.

A look at Square stock's valuation

A quick glance at Square's valuation could lead investors to conclude that its shares are overvalued. The company trades at steep price-to-sales and price-to-earnings ratios of 7.3 and 120, respectively.

But a surface-level look at Square's valuation metrics misses key elements to its growth story and competitive positioning, including its strong top-line growth, how entrenched its customers are in its systems, its positioning amid strong secular tailwinds like businesses' digital transformations, and its substantial gross profit growth potential.

That last point in particular is worth a closer look. While Square's 40% boost to gross profit last quarter was notable, it understates the company's momentum on this key profitability metric. Square's higher-margin subscription and services-based offerings are generating outsize gross profit growth, with gross profit increasing 61% year over year in Q1. Further, one catalyst within this segment is growing at an extraordinary rate. Gross profit for Cash App -- a consumer-facing peer-to-peer payment app with a growing suite of financial services for its users --  jumped 115% year over year in Q1. As these services grow and provide larger shares of Square's revenue, this could accelerate its bottom-line progress.

A man using the Square Cash App

Cash App. Image source: Square.


No investment, of course, is without risk. Buying growth stocks is particularly risky since the market has already priced years of strong growth into their valuations. Investors without the stomach to hold shares for the long haul and endure significant volatility along the way should therefore avoid Square. Further, investors would be wise to keep their positions small given the significant haircut the stock could take if the company falls short of investors' high expectations.

In addition, Square is up against some fierce competition, namely Shopify. But there's plenty of room for multiple solutions and providers in this market. The overall digital transformation market is expected to grow from $290 billion in 2018 to $665 billion in 2023. Moreover, investors don't have to guess whether or not Square is fit to hold its own against competition; recent execution already proves its strong value proposition to sellers. Square has clearly carved out a strong position for itself in a fast-growing market.

Overall, this stock's pricey valuation today is well-deserved. It's is a reflection of the great momentum Square has. Investors who buy and hold the stock for the long haul could be rewarded handsomely.

Daniel Sparks has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Shopify and Square and recommends the following options: short September 2020 $70 puts on Square. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Block, Inc. Stock Quote
Block, Inc.
$87.18 (-0.88%) $0.77
Shopify Inc. Stock Quote
Shopify Inc.
$39.70 (-2.60%) $-1.06

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/15/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.