Etsy (ETSY 2.47%) has been a fantastic stock to own, skyrocketing in value more than 1,300% over the past five years. This eye-popping return can be attributed to remarkable revenue and profit growth. Riding the worldwide e-commerce boom didn't hurt, either.
However, what makes Etsy really special is its ability to continue growing at a fast rate with minimal capital investment required. And that's why the company's most important number right now is 24%.
Read on to learn more.
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Playing with house money
The overarching goal of any for-profit enterprise is to not only generate net income, but also free cash flow. This is basically the money a company has left over after paying all of its expenses, such as marketing, product development, salaries, and investing in growth initiatives, like software and equipment. If a business doesn't currently generate cash or there isn't a clear path for it to do so, shareholders generally won't be happy. And eventually, the company won't survive.
In Etsy's case, because the company is strictly an online marketplace that facilitates transactions between its 5.2 million active sellers and 90.5 million active buyers, it requires virtually no capital to grow. During the first six months of 2021, Etsy's free cash flow margin was 24%, which means that for every dollar of revenue, the company produced $0.24 in cash. This is truly exceptional, and it underscores how lucrative Etsy's business model is.
The company is a platform that already has the technological foundation in place to handle buyers and sellers. Building this software, with payments, advertising, and security capabilities, requires a large investment upfront. But each customer transaction costs almost nothing to process, so all Etsy needs to worry about is boosting the volume that occurs on its site. And after a certain point, profitability soars. Over the last 12 months, Etsy's gross merchandise sales (GMS) totaled $12.4 billion. The company's operating margin has also significantly expanded over time, from 0% in 2015 to 25% in 2020.
Look for this characteristic
"The best business is a royalty on the growth of others, requiring little capital itself."
These are the words of Warren Buffett, who is arguably one of the greatest investors of all time.
Looking for this trait when seeking companies to invest in is a solid strategy. Because Etsy doesn't own any inventory itself, like a traditional retailer would, it is basically growing on the backs of the investments its sellers make into their own small businesses.
If a skilled tailor in France wants to sell handmade face masks during the pandemic, she takes on all the financial risk of doing so by buying the fabric and tools herself. And if an artist in Australia thinks his custom paintings might have global appeal, it's up to him to purchase the necessary supplies to make it happen. Etsy simply provides these entrepreneurs with a connection to potential buyers. Buffett would certainly appreciate this arrangement based on his statement above.
And since Etsy does produce a lot of cash, it has the freedom to pursue acquisitions, like that of musical instrument marketplace Reverb, or recent purchases like Depop and Elo7, to further support its expansion efforts. This is quite an enviable position to be in.
Growth has been tremendous, and Etsy's financial situation is superb. The free cash flow margin of 24% is indicative of this, and it's the most important number for shareholders to pay attention to.
