Lemonade (NYSE:LMND) was one of the hottest tech IPOs of 2020. The online insurer priced its shares at $29 last July, but the stock opened at $50 and eventually hit an all-time high of $188 a share this January.

Since then Lemonade's stock price tumbled to about $60 by mid-May. The Texas winter storm in February sparked an unexpected surge in insurance claims, while inflation concerns in the broader economy torpedoed frothier growth stocks like Lemonade.

Lemonade's stock price has subsequently rebounded above $100 a share again, but is this volatile stock worth buying at these levels? Let's discuss three reasons to buy Lemonade and one reason to sell it.

A smartphone user sips lemonade while using a phone.

Image source: Getty Images.

1. Lemonade has disruptive potential

Lemonade simplifies the byzantine process of signing up for insurance with a single app. Its service, which uses AI-powered chatbots instead of human sales representatives, insures users within 90 seconds and processes many claims within three minutes.

Lemonade initially only offered home and renters' insurance, but it launched pet and term life insurance products over the past year. It also plans to launch auto insurance plans later this year.

Lemonade plans to disrupt the aging and fragmented insurance market, which can be baffling for younger buyers, with its simple app. About 70% of Lemonade's customers are under the age of 35, and many of them are first-time insurance buyers.

2. Lemonade's growth rates are robust

Lemonade ended last quarter with nearly 1.1 million customers, but that represents a tiny sliver of the adult population in the U.S.

Its total customers, in-force premium, premium per customer, and gross earned premium all continue to rise at high double-digit percentage rates. That robust growth indicates its disruptive approach is catching on.

Growth (YOY)

FY 2020

Q1 2021

Customers

56%

50%

In-force premium

87%

89%

Premium per customer

82%

25%

Gross earned premium

110%

84%

Data source: Lemonade. YOY = Year over year.

It also ended the first quarter with an annual dollar retention (ADR) rate of 81%, up from 70% a year ago and just 67% in the first quarter of 2019. That rising ADR indicates its platform is getting stickier.

3. Lemonade's slowdown is temporary

The bears pounced on Lemonade earlier this year after its gross loss ratio skyrocketed to 121% in the first quarter after the winter storm.

But even after absorbing that impact in the first quarter, it maintained its prior adjusted EBITDA forecast for a loss of $163 million to $173 million for 2021. That's wider than its loss of $97.9 million in 2020, but that unchanged forecast suggests its gross loss ratio should cool off later this year.

Furthermore, Lemonade raised its full-year revenue guidance from 21%-24% growth to 24%-28%, which indicates its growth in customers and premiums will remain healthy. 

The one reason to sell: Lemonade's valuation is high

Lemonade's growth potential is exciting, but its valuation clearly reflects that excitement. The stock currently trades at about 55 times this year's sales, making it one of the market's priciest tech stocks.

Many other tech stocks that generate 20%-30% revenue growth annually are trading at much lower valuations. The cloud-based enterprise software giant salesforce.com (NYSE:CRM), for example, trades at roughly nine times this year's sales, while analysts expect its full-year revenue to rise 22%.

Lemonade is also much more expensive than traditional insurers like Allstate (NYSE:ALL) and The Travelers Companies (NYSE:TRV). Both those companies are consistently profitable, and their stocks trade at around one times this year's sales.

These older insurers operate their own mobile apps, so Lemonade hasn't cornered the market for app-based insurance yet. These rivals might also start targeting Lemonade's customers with lower prices.

Lemonade's valuation might be justified if it gains tens of millions of new customers over the next few years. But unless that happens, Lemonade could struggle to convince investors that it's all that different from traditional insurance companies without its AI chatbots, algorithms, and streamlined app.

It's a speculative investment -- for now

I own a small position in Lemonade because I admire its disruptive potential, but I definitely wouldn't recommend the stock as a core holding. The company is clearly still growing, but it's unclear if it can ever grow into its frothy valuation -- so investors should do their homework before buying this volatile stock.

 
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.