Unity Software (U -0.81%) has been one of the best-performing IPOs of 2020, with the stock up over 100% since its debut in September. As the backbone for much of the world's real-time 3D (RT3D) content (think mobile gaming, augmented reality, design tools, etc.), the company has a lot of potential for growth. However, with a market cap north of $42 billion and guidance for only $754 million in 2020 sales, shares of Unity look to be a bit inflated.
Here's what any prudent investor should be thinking about when evaluating the stock.
The business is doing outstandingly well
Last quarter, Unity's revenue grew 53% year over year to $200 million, and it's guiding for full-year sales growth of around 40%. It also had a dollar-based net expansion rate of 144%, which essentially means sales growth from existing customers was 44%. This shows how big of an opportunity creating/monetizing mobile gaming has become, and it is a big reason Unity now has 739 customers generating at least $100,000 in annual sales versus only 553 a year ago.
The company just inked a partnership with Snap (SNAP -0.72%), the company behind the popular messaging service Snapchat and maker of the innovative AR glasses called Spectacles. Unity's advertising supply (the main way it helps companies monetize their content) will now be available for the Snap Audience Network and its 249 million daily active users. This should be a boon for Unity's advertising segment, but the biggest news was the fact that Unity developers will now get access to the Snapchat software development kit (SDK). Snap is investing heavily into gaming and AR content, so a partnership with Unity makes a lot of sense here, and should be a win for both companies.
In non-gaming RT3D content, Unity has an ongoing partnership with Autodesk (ADSK 0.66%), the leader in design software for architecture, engineering, and construction firms. Autodesk has over 5 million subscribers across its various services, all of which should benefit from the visualization capabilities Unity's tools provide. Non-gaming is only a small part of Unity's revenue at the moment, but with the company already powering 50% of the world's mobile games, it will need to be a large part of its growth going forward.
As you can see, there are a lot of reasons to be excited about Unity's future prospects.
The stock looks like its getting out over its skis
At 56 times 2020 sales, it is going to take a lot of growth for Unity to fulfill its current valuation. Yes, it has a high gross margin (78% over the last nine months) and recurring revenue business in a rapidly growing industry, but a price-to-sales ratio above 50 is just too much. Even if the company boosts its revenue by a factor of 10 over the next few years (not a guarantee by any means), it is still hard to see how much more stock appreciation investors will get over the long term when the company's market cap is already currently above $40 billion. You never want to bet on being able to buy shares in a pullback (market timing is a wild goose chase), but if you're bullish on Unity's potential, this might be a time that it pays to be patient.
Great companies like Unity typically trade at a premium valuation. But just because the business looks like a sure thing doesn't mean you should ignore the price it trades at.