Like many high-growth stocks, Shopify (SHOP 0.56%) has taken a beating over the past three months. Shares are down 42% since late November and are now down almost 25% in the last 12 months. Plenty of smart investors are saying that now is the time to buy the dip on Shopify stock.
They might be right over the very long run. However, I currently disagree; I think investors are anchoring to recent high prices, and ignoring how expensive Shopify stock is on an absolute basis.
Here's why I'm still not buying Shopify stock, even after this rapid sell-off.
The business continues to grow
Before getting into the stock analysis, let's put some context around Shopify's business. In Q3 of 2021, which ended in September, Shopify's revenue hit $1.12 billion, growing 46% year over year. Top-line growth is driven by Shopify's two core segments: subscriptions and merchant solutions. Subscription revenue is the dollars that Shopify brings in from people and businesses subscribing to get access to its website and e-commerce building tools. This segment hit $366.2 million in Q3, growing 37% year over year.
The larger and more important segment is merchant solutions; this is mainly the revenue Shopify earns when people spend money on its websites. Revenue for this segment was $787.5 million in Q3, up an impressive 51% year over year. Gross payment volume (GPV) -- the amount of money processed with Shopify Payments -- hit $20.5 billion in Q3, accounting for much of this revenue.
Shopify has not been consistently profitable, but it does generate positive cash flow and has fairly high margins. Over the last twelve months, free cash flow (FCF) was $458 million, with gross margins of 54.5%. It is hard to predict what Shopify's FCF or profit margins will be at maturity, but given its gross margin, it likely will not be much higher than 20% or 25%.
Price-to-sales is back to pre-pandemic levels
The main reason investors are excited about Shopify is that the stock is now back around its pre-pandemic price-to-sales ratio (P/S) of 26.5. Combine that with how the stock has performed since the beginning of the pandemic, and the impressive growth numbers the business continues to put up, and many see good reasons for excitement.
However, I don't believe comparing multiples is the right way to go. Instead, look at the current market cap of Shopify, evaluate how much cash and earnings you think it can generate over the coming years, and decide whether the current price is at a point where you'd be comfortable owning the business for the long term. Let's go through that now.
Forward expectations are still too high
Shopify's trailing-12-month revenue is around $4.2 billion and growing 46% year over year. Its market cap is currently $111 billion. If you're optimistic about Shopify's business prospects, you might expect revenue to grow at 30% over the next few years (the percentage growth numbers will come down as the absolute dollar numbers balloon in size). If that occurs, it will take Shopify around three years to reach $10 billion in annual revenue. If we assume FCF margins can reach 20%, Shopify could be generating $2 billion in free cash flow three years from now ($2 billion is 20% of $10 billion).
Compared to its current market cap, that gives Shopify stock a three-year forward price-to-free-cash-flow (P/FCF) of 55.5 (111 divided by 2) if it can hit those numbers. The Nasdaq Composite's average P/FCF right now is 31. If you're confused, all these numbers mean is that even though Shopify's stock is down a lot, investors still have very high growth expectations for the company. You will need to as well if you're going to buy shares.
Historically, paying up for Shopify stock has worked well, given that shares are up over 1,000% in the last five years. However, at the start of this big run-up, Shopify's price-to-sales ratio (P/S) was only around 15-20, while today it sits at 26. The company is also doing much more in annual revenue now, at $4.2 billion in the last twelve months compared to $673 million in 2017. This will make it harder to combat a high current P/S and look-through P/FCF, which is what is needed for investors to get strong returns in the stock over the next decade.
Given this premium valuation and the fact that the company is more mature than it was five years ago, I'm not comfortable owning Shopify shares right now, even though I'm confident the business can grow substantially over the next decade.