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Why Square's Stock Is So Expensive

By Will Healy - May 28, 2021 at 6:45AM

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Square's growing competitive advantage could justify its expense.

More than a year out now from the start of the pandemic, Square's (SQ -0.76%) investors have prospered, benefitting from the accelerated digitization of retail, the renewed popularity of Bitcoin, and a relatively quick recovery in the fintech sector after the March 2020 sell-off. While the stock price increases have made Square an expensive stock, a growing competitive advantage the company is building on could help justify its expense.

Just how overpriced is Square?

By most measures, Square has become an expensive stock. It was boasting a P/E ratio of just over 305 at the time of this writing. The S&P 500's current P/E multiple of 45 pales in comparison, even though that index has reached multi-year highs. Square also trades far above archrival PayPal's (PYPL 0.44%) P/E ratio of 60.

A young adult holding a smartphone and a credit card preparing to make a financial transaction.

Image source: Getty Images.

However, one reason Square has become expensive is its performance. Square's stock price has risen by 170% over the last year, compared with just over 70% gains for PayPal. Square's return increases to 430% when compared with the March 2020 low.

SQ Chart

SQ data by YCharts

Still, recent financials appear to not justify such an earnings multiple. An accounting rule requiring the company to count the value of Bitcoin transactions as revenue skewed revenue figures. However, when not counting Bitcoin, revenue still rose 44% in the latest quarter from year-ago levels. Moreover, the $39 million profit came in much higher than the $106 million loss in the same quarter last year.

Furthermore, the stock is in recovery mode since the pandemic brought falling profits in 2020. Revenue for 2020 still increased by 17% compared with fiscal 2019. Nonetheless, the company also experienced a 47% increase in operating expenses. Even with $292 million in income from non-core sources, net income fell to $213 million, a 43% reduction from last year's levels.

Outside of increases in Cash App-related profit and operating expenses, Square did not publish forward guidance. Still, the predicted 167% increase in Cash App net income for the second quarter could comfort investors who paid the stock's current valuation.

Also, before the pandemic, revenue increased 43% in fiscal 2019, and Square reported its first annual profit of $375 million that year. The 2019 revenue figure comes in near the revenue increase in Q1 2021, indicating pre-pandemic growth rates have returned. Additionally, such increases have led to a forward P/E of 145, a reduction that could ease the sting of Square's current valuation.

Why investors should consider it despite the expense

Despite recovering financials, Square may justify its expensive stock through a key competitive advantage: a more comprehensive finance ecosystem. Yes, PayPal reaches over 200 countries compared to Square's current five countries. PayPal also can manage most personal finance functions between PayPal and Venmo, which competes directly with Cash App.

However, Square announced that it will soon open up to sellers in Ireland. Since this could easily take Square into the 18 other European Union countries that use the euro, investors should not discount Square's international aspirations.

Moreover, PayPal does not offer the equivalent of Square Register or Square Payroll to handle business transactions and payroll, respectively. This means that only Square accommodates both individuals and businesses in its ecosystem.

Furthermore, the most critical business-related function may pertain to its bank charter. As a bank, Square can make business loans without bringing in a third party. Additionally, according to Bloomberg, Square will soon offer business and checking accounts, meaning businesses that want to fully embrace fintech no longer need a traditional bank. That could spell further trouble for banks if Square starts offering these services to individuals.

From the stockholder's perspective, this move could also lead to charges that Square will "take over finance." That fear stands little chance of becoming reality, and investors should expect some banks to adapt and survive. Nonetheless, the perception could stoke investor interest in Square that comes at the expense of banks.

Where Square stands

Indeed, Square's current earnings multiple can undoubtedly put off investors. However, with its Cash App driving triple-digit percentage income growth and its growing finance ecosystem, it appears poised to bring profound change to its industry. As conditions stand now, it could easily win business from traditional banks and bring massive transformation to the industry. As it adds customers and expands to more countries, today's stock price may not appear expensive for long.

Will Healy owns shares of Square. The Motley Fool owns shares of and recommends Bitcoin, PayPal Holdings, and Square. The Motley Fool recommends the following options: long January 2022 $75 calls on PayPal Holdings. The Motley Fool has a disclosure policy.

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