Cathie Wood Is Almost Certainly Wrong About Zoom Stock

Cathie Wood is head of Ark Invest, an investment firm that manages various exchange-traded funds (ETFs). Its flagship ETF is the Ark Innovation ETF (ARKK 0.07%), in which Zoom Video Communications (ZM 0.05%) stock is the top holding and makes up nearly 11% of the fund.

On June 8, Ark Invest made headlines by predicting that Zoom stock would reach $1,500 per share by 2026 -- more than a 13-bagger from where the stock trades right now. I think Wood is almost certainly wrong on this price. But allow me to explain why I still believe it's directionally correct and why you should care. 

The investment thesis for Zoom

Ark Invest actually has three price targets for Zoom: a bear case of $700 per share, a medium case of $1,500, and a bull case of $2,000. These numbers aren't pulled from thin air, but rather are based on a series of clearly articulated assumptions about Zoom's business.

In short, Ark Invest published an investment thesis -- a succinct summary of things it believes will happen to create shareholder value over a period of time. It's something that every investor should develop and be able to communicate before investing in any stock.

To briefly summarize, Ark Invest expects mind-blowing revenue growth from Zoom by 2026. Here are the main elements of the thesis:

Data source: Ark Invest. 

Ark Invest expects Zoom to more than septuple its revenue over four years. That's about a 65% compound annual growth rate (CAGR) for revenue. For perspective, Zoom's management expects 11% revenue growth this year at best. Therefore, growth would have to drastically accelerate in subsequent years to remotely approach Wood's projections.

In Ark Invest's model, Zoom would be generating about $52 billion in annual revenue in 2026 at a 26% free-cash-flow (FCF) margin and have a market capitalization of around $510 billion. So the model is calling for $13.5 billion in FCF, which would be outstanding. And the model expects the stock to trade at 37 times this FCF.

Why I love investment theses

In the short term, stocks are volatile, trading outrageously higher and depressingly lower as investors' emotions bounce around. Zoom stock itself is exemplary in this regard. Since going public three years ago, it's traded as low as $62 per share, to as high as $568 per share, and all the way back down. Zoom's business hasn't fluctuated as much as how the market feels about it.

Without a thesis, investors can't discern if things are going right or wrong because the stock price isn't a reliable indicator in the short term. Therefore, an investment thesis provides a tangible measuring stick.

However, every investment thesis will eventually prove somewhat wrong because humans aren't omniscient. The same goes for Wood's thesis on Zoom -- at least something won't play out as foreseen. Specifically, I find it unlikely that Zoom will grow revenue as fast as Ark Invest forecasts. And a stock trading at 37 times free cash flow (FCF) has a generous valuation. Consider that Zoom stock currently trades around 20 times its adjusted FCF. That means Ark Invest is expecting the valuation to nearly double, which seems unreasonable.

Investment theses are often wrong in the details and yet are still indispensable. Simply ask yourself how many assumptions can be wrong before the thesis is invalidated entirely.

When it comes to Zoom specifically, I agree directionally with many of Ark Invest's assumptions. For starters, I believe that Zoom can keep growing its customer base, as evidenced by how the company continues to add new customers sequentially even as it laps impressive gains from earlier in the COVID-19 pandemic. 

Zoom's customer base also continues to spend more over time. Zoom's newer products like Phone and Rooms are driving this expansion and can continue to drive this spending growth in coming years.

And when it comes to FCF, Zoom has long been a stalwart, with an adjusted FCF margin of 46% in Q1. I believe the company will remain strong in this area even if the margin contracts.

I believe Wood's investment thesis for Zoom stock is aggressive and it likely won't hit Ark Invest's price target. However, while I don't believe investors should expect a 13-bagger, I do believe Zoom can double or more over the next four or five years based on its business trajectory. This would likely make Zoom a market-beating investment. And beating the market is what matters.