Investors in Roblox (RBLX 3.60%) have had a bumpy ride lately. After closing at $70 on its first day of trading, the gaming platform's stock surged to a high of $140 in the subsequent months. The stock price has since dropped by more than 55%.
While existing investors might be upset with the recent share price correction, those who have missed the boat earlier have another opportunity to buy Roblox stock on the cheap. But should they grab it?
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What to like about Roblox
There are many reasons investors might find Roblox a compelling investment opportunity. To start, it has demonstrated an excellent execution track record, evident in its strong financials -- revenue surged almost threefold from $313 million in 2018 to $924 million in 2020, thanks to the growth in Roblox's user base.
While important, these financials only tell us part of the story. The numbers also demonstrate the resilience of Roblox's business model, which the company has fine-tuned over the last 17 years.
There are two parts to Roblox's business model. On one end, the platform helps facilitate the relationship between developers and gamers -- developers focus on creating the best games while the gamers reward them by spending money on virtual items. These developers usually reinvest part of their earnings to improve their games, which helps retain existing users and attract new ones. The result is a mutually beneficial relationship with ever-growing (and better quality) content and an expanding user base.
But this is just one part of the equation. The other part revolves around the social element of Roblox's platform. As users join Roblox, they naturally invite their friends to join them. These new users, in turn, invite their other friends to join Roblox. In other words, the virtual cycle of ever-growing content and user base is reinforced because of the platform's social aspect. The tech company is working hard to broaden its use case -- for example, an artist can already launch their new music exclusively on Roblox while a team can collaborate live using Roblox for work purposes.
As Roblox's use case expands, its user base will diversify from the early gaming-centric community. A diversified user base will aid the company in its monetization effort. Currently, Roblox primarily generates revenue from taking a cut on every virtual transaction on its platform. In the future, the gaming company aims to expand its income streams by launching new services such as advertising, subscriptions, e-commerce, and more.
What not to like about Roblox
So far, we have looked at the positive sides of investing in Roblox. But our job won't end until we consider Roblox's valuation.
To begin with, investors would expect Roblox to trade at a high valuation due to its good prospects. And based on its latest share price of $58.60 (as of this writing), Roblox trades at a price-to-sales (P/S) ratio of 17 times. This valuation is still steep, especially if we compare that to other leading technology companies like Meta Platforms (FB +6.49%), which trades at P/S ratio of less than eight.
While it's not uncommon for high-growth stocks to trade at a high valuation -- for example, Unity Software (U +0.95%), another gaming software platform, trades at over 25 times sales -- a high valuation does pose significant risks. The most obvious is the upcoming increases in interest rates. A higher interest rate is a drag on stock price, particularly on high-growth stocks. On one end, it makes it more expensive for growth companies to raise capital for future expansion. Moreover, as Roblox is still still taking losses, the majority of its intrinsic value will come from future cash flow many years ahead. A higher interest rate makes future cash flows less valuable in present value terms. Besides, a high valuation also means that investors have high expectations from Roblox. If the company fails to keep up with those expectations, such as sustaining its high growth rates, its valuation may have to come back down to earth in the short term.
On top of that, the metaverse has increasingly become a new battleground for start-ups and established companies. In particular, Meta Platforms' official entry into this industry means that Roblox can no longer keep the whole pie to itself. With 2 billion users and plenty of resources (in terms of both cash and talent), Meta is going to be a threat to Roblox's global ambition. Fortunately, the industry is probably large enough for multiple players to succeed in the long term. Besides, Roblox has had a head start of many years, and so long as it can continue to innovate and maintain its first-mover advantage, it may still be a viable long-term stock pick..
Is Roblox a buy?
Roblox has a lot going for it as it expands its use case and rides the metaverse trend. So long as it can continue to attract and delight its developers and users, there's a good chance that it will sustain growth for years to come.
Still, investors need not rush into buying the stock. Even after its recent correction, Roblox might still be considered expensive. Hence, for investors who are convinced about Roblox's prospects, it will be prudent for them to wait for a better entry point, or initiate a small position now and add to that position over time as the company executes.
