If you opened this article to read, the odds are good that you want to know what to do with Shopify (SHOP 0.28%) stock. At the moment, the stock is up 75% year to date. For some investors, this is a sign to sell, since it's already had a good run-up. For others, this is a buy signal because things must be improving and shares still have a long way to go before reaching a new all-time high.
Too often, investors only look at the stock's price performance to decide what they should do. This article will take a different approach, looking at where Shopify stock is headed based on the business and the valuation. Hopefully, it will provide a better idea of whether Shopify stock is a buy, sell, or hold.
Fresh financial results to analyze
On Nov. 2, Shopify reported financial results for the third quarter of 2023 and the stock price jumped on the news. It's safe to assume the market was impressed with something in the report. And this might be a clue to what investors should pay attention to.
To understand the current report, it helps to be aware of two crucial things that happened in 2022 for Shopify. First, its revenue growth rate fell to its lowest level ever as a public company. Second, its free cash flow -- a measure of profitability -- also fell to its lowest point ever (see the chart below).
SHOP Revenue (Quarterly YoY Growth) data by YCharts
Since hitting rock bottom in 2022, Shopify's business has bounced back significantly in 2023, and Q3 results showed a continuation of its improvements. This is what the market has been impressed with.
In Q3, Shopify's revenue was up 25% year over year to $1.7 billion. But this doesn't tell the whole story when it comes to growth. Retailers use Shopify's products for e-commerce operations. And the company measures total sales for its merchants with a metric called gross merchandise volume (GMV).
Shopify's GMV for Q3 was up 22% year over year, its best growth rate since 2021. But the driver of growth here is important to note. According to management, its GMV was up "primarily" from having more merchants using its software products than before. In other words, volume growth is coming from customer growth, which is huge.
Additionally, Shopify's profits were up for an important reason as well. Typically, the company's gross profit margin hovers around 55%. But in 2022, it dipped below 50% for the first time as the company tried to build out a logistics business (see the chart below).
SHOP Gross Profit Margin (Quarterly) data by YCharts
Now that it's offloaded its logistics business to its partner Flexport, Shopify's gross margin is bouncing back. In Q3, its gross margin was 52.6%, which was up sharply from its gross margin of 48.5% in the prior-year period -- that's a huge difference for a multibillion-dollar business like Shopify.
Its higher gross margin is enabling better profitability, including free-cash-flow profitability. Shopify now has four consecutive quarters of positive free cash flow, and the market loves it.
What to do with Shopify stock now?
If I were to buy Shopify stock today, I'd want to be sure that these things can continue: I want to see growth and margin improvement. The problem is that these things are expected to take a step back in the last quarter of 2023. According to management, Shopify's fourth-quarter revenue will increase by a high-teens percentage, which is good. But it is a slower growth pace than its Q3 revenue growth and slower than its 26% growth in the fourth quarter of 2022. So it's a step back.
Moreover, management expects Shopify's Q4 gross margin to fall back below 50%. Typically, the fourth quarter's margin is lower than the rest of the year. This is due to revenue being driven by transactions, and transaction-based revenue tends to be lower margin. Therefore, this isn't necessarily uncommon.
The potential that Shopify's growth and profit margins will step back next quarter gives me pause.
Another reason to be cautious when it comes to Shopify stock is its valuation. Right now, the stock has a price-to-sales valuation of about 12, which is roughly what it was way back in 2016.
However, as the chart below shows, Shopify's growth rate was far superior in 2016. The company's gross margin was also better. And finally, interest rates were lower in 2016, which has a tendency to boost investment valuations. Therefore, for these three reasons, you'd expect Shopify's valuation to be lower now than it was back then, but it's not.
SHOP Revenue (Quarterly YoY Growth) data by YCharts
For these reasons, I'm not a buyer of Shopify stock today. That said, if I owned the stock, I wouldn't be a seller either, because it is a strong business in many respects. Therefore, I believe the strongest case is for holding Shopify stock today if you're already a shareholder. And for those who aren't shareholders, I'd wait on the sidelines for a better price or a material improvement to the business before buying shares.
