Duolingo's (DUOL 3.73%) stock plunged 14% on July 11 after KeyBanc analyst Justin Patterson downgraded the stock from an "overweight" rating to a neutral-equivalent "sector weight" rating.

In a note to investors, Patterson predicted that "headwinds from inflation and signs of softness in other freemium apps" could result in downward earnings revisions for Duolingo "over the coming quarters." Therefore, Patterson claims that its stock is now "appropriately" valued -- even though it's now trading below its IPO price of $102 per share.

Should investors stay away from Duolingo after that cautionary statement? Or is its recent pullback a good buying opportunity for long-term investors?

Two people check their smartphones together.

Image source: Getty Images.

How fast is Duolingo growing?

Duolingo provides online language courses through its website and mobile app. It monetizes its free users with ads and provides an ad-free experience with extra perks through its paid Duolingo Plus subscriptions for $6.99 per month. The company also provides the Duolingo English Test, a proficiency test for non-native English speakers, as a stand-alone service for $49.

Duolingo generated 71% of its revenues from subscription fees in its latest quarter, and the rest came from its ads and other services. Its total bookings and revenue have both risen rapidly over the past two years.

Metric

FY 2020

FY 2021

Q1 2022

Bookings (Millions)

$190.2

$294.2

$102.1

Growth (YOY)

116%

55%

55%

Revenue (Millions)

$161.7

$250.8

$81.2

Growth (YOY)

128%

55%

47%

Data source: Duolingo. YOY = Year-over-year.

For the full year, Duolingo expects its bookings to rise 32%-35% and for its revenues to grow 39%-43%. Analysts expect its revenue to increase 41% this year and 27% in 2023.

Duolingo's year-over-year growth in monthly active users (MAUs), daily active users (DAUs), and paid subscribers cooled off last year against a challenging comparison to the pandemic, which had prompted more people to take online language lessons at home. However, its user and subscriber growth stabilized and accelerated again in the first quarter of 2022.

Metric

FY 2020

FY 2021

Q1 2022

MAUs (Millions)

36.7

40.5

49.2

Growth (YOY)

34%

10%

23%

DAUs (Millions)

8.2

9.6

12.5

Growth (YOY)

58%

18%

31%

Paid Subscribers (Millions)

1.6

2.5

2.9

Growth (YOY)

78%

56%

60%

Data source: Duolingo.

Between the end of 2020 and the first quarter of 2022, Duolingo's percentage of DAUs which were also paid subscribers rose from 19.5% to 23.2%. If that ratio keeps rising, Duolingo's margins should improve.

During the first-quarter conference call, CEO Luis von Ahn said the company "converted a record number of new paid subscribers" and "retained more of our previous subscribers." He also said there was still a "massive opportunity" for long-term growth in the "$50 billion" language learning market and that Duolingo was still the "largest player online."

Duolingo was temporarily suspended in China along with other apps during the industrywide crackdown on online education services last year, but it was allowed to return to the country's app stores last month. That long-awaited return could generate fresh tailwinds for its international business.

How profitable is Duolingo?

Duolingo wasn't profitable by GAAP (generally accepted accounting principles) or adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) measures back in 2019. However, its adjusted EBITDA has been gradually stabilizing.

Period

FY 2020

FY 2021

Q1 2022

Net Income (Millions)

($15.8)

($60.1)

($12.2)

Adjusted EBITDA (Millions)

$3.6

($1.1)

$3.9

Source: Duolingo.

For the full year, Duolingo expects its adjusted EBITDA to come in between $0 to $3.0 million. Analysts expect it to post a positive adjusted EBITDA of $1.6 million in 2022, followed by a big jump to $25.6 million in 2023.

That projection seems extremely bullish, but it's likely based on the assumption that Duolingo will keep gaining active users, its ratio of paid subscribers will continue climbing, and it will rein in its operating expenses as economies of scale kick in. Its margins could also improve significantly if Alphabet's Google and Apple are forced to further lower their app store fees.

Is Duolingo's stock worth buying right now?

Duolingo's stock closed at an all-time high of $202.69 last September. At the time, it was valued at $7.6 billion, or 26 times the revenue it would generate in 2021. Today, it's valued at just $3.7 billion, or ten times the revenue it's expected to bring in in 2022.

Duolingo looks a lot cheaper today, but it still can't be considered undervalued since plenty of other growth stocks -- some of which are firmly profitable -- are now trading at single-digit price-to-sales ratios. Duolingo could still have a lot of room to grow, but its premium valuation could limit its upside potential in this challenging market for growth stocks. Therefore, I'd have to agree with KeyBanc's cautious assessment -- it's just not a screaming buy right now.