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I Love The Trade Desk: Here's 1 Big Reason Why I Won't Buy the Stock Right Now

By Lawrence Nga - Dec 1, 2020 at 8:23AM

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Buying The Trade Desk's stock is a risky thing to do.

The Trade Desk ( TTD -7.93% ) has been one of the best-performing stocks over the last few years, gaining a mindboggling 4,800% since its IPO in 2016, thanks to solid revenue growth and an ever-expanding valuation.

But that's history. The more important question to ask now is whether to buy the stock today. Let's explore that question further.

What to like about the company

There are plenty of good things to say about this tech company that helps customers optimize their digital ad spend.

Woman with palm on her forehead.

Image source: Getty Images

I'm impressed with the robustness of The Trade Desk's business model, evident in its third-quarter 2020 results. While most companies faced enormous challenges amid the pandemic, The Trade Desk reported record revenue of $216 million, up 32% from last year. Net income more than doubled to $41 million thanks to the company's revenue growth and operating leverage. This demonstrates the resilience of the business, which continued to perform during one of the worst recessions in the last 100 years.

I also like that founder Jeff Green is still CEO of the company and owns more than $5 billion of The Trade Desk stock. As an owner-operator, Jeff has the incentive, as well as the power to lead the company toward success. So far, he has a phenomenal track record: Revenue rose 14-fold between fiscal 2014 and fiscal 2019. On top of that, The Trade Desk has been profitable since 2013!

With a resilient business model and a founder at the helm, The Trade Desk is well-positioned to sustain its growth on the back of two major secular trends: the continued shift toward digital advertising and the transition to programmatic advertising. According to its recent presentation, it has less than 1% of the total global ad market -- the total addressable market stands at $725 billion -- giving it plenty of room for growth.

A good company, but a bad stock

From the above arguments, it's easy to see that I'm very bullish about the company. In fact, The Trade Desk fits nicely into my description of a high-quality business: one that has a robust business model, a solid track record, and a long runway for growth.

However, a good company trading at the wrong valuation can be a bad stock to own. In this case, I think The Trade Desk is a bad stock due to its nose-bleed valuation.

After the recent run-up in share price, The Trade Desk's stock is trading at an astronomically high valuation of 299 times trailing earnings. At such a valuation, the company must execute flawlessly over the next few years or face the risk of a significant price correction. For perspective, shares of Fastly (another fast-growing technology company), have plunged by about 40% since the company missed analyst targets in October.

If The Trade Desk executes perfectly, it will probably grow earnings at least 20% to 30% annually. (The analyst consensus calls for 29% annual earnings-per-share (EPS) growth over the next five years.) And if it could sustain its P/E ratio, it would clearly generate market-beating returns. The downside is that the P/E ratio might contract over time. For perspective, if EPS grows at 29% annually over the next five years but the P/E ratio falls to 100 -- still extremely high by any conventional standard -- the total investment return over the period would be a paltry 19%.

The final verdict

The Trade Desk is well-positioned to grow over the next few years as it rides the connected-TV trend and expands its operation globally. Understandably, investors are excited about the company, sending its stock to trade close to its all-time high.

Yet this high valuation renders the stock extremely risky. All things considered, I prefer to stay on the sidelines for now (and advise investors to do the same), even if that means I might miss some short-term upward price movement.

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.

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