Shopify (SHOP 1.11%) is up over 120% since the start of 2023, more than doubling the Nasdaq Composite's returns over that time frame. But the stock's impressive performance has left many prospective buyers concerned that the train may have officially left the station on this investment idea.
It's certainly tougher to justify purchasing Shopify stock at these more expensive valuations, but there might still be something compelling here for the right type of investor. Let's dive in and take a look.
Continuing the momentum after a huge year
The company's share price gains have been driven by a combination of strong fundamental performance and surging investor confidence. Revenue grew 24% year over year in the fourth quarter, and that figure was closer to 30% after adjusting for the impact of its divested logistics business. Free cash flow more than quadrupled from the prior-year period as the company moved into positive cash flow territory and charged closer to profitability.
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Meanwhile, Shopify stock's price-to-sales ratio increased by nearly 70% to 14, while its forward price-to-earnings (P/E) ratio rose more than 40% to 56. These shifts indicate that investors are willing to pay a higher premium relative to the company's financial fundamentals. That's a reflection of increased confidence about its future performance. It's also likely enhanced by the expectation that interest rates will fall; lower interest rates generally encourage investors to take on a greater level of risk.
SHOP PS Ratio data by YCharts.
Shopify stock trades at more expensive valuations than it did at the start of last year, so it's fair for investors to wonder if they've missed the boat. If the current valuation ratios have priced in too much going right in the future, then there won't be much upside potential unless the stock tumbles. It becomes a question of whether the new valuation fairly reflects the company's future prospects.
Keeping the momentum rolling
Shopify's revenue has marched steadily higher since the start of 2021, but its growth rate tumbled significantly as the health crisis and social distancing phases of COVID-19 receded. People started going back to stores, so e-commerce wasn't quite the dominant force it had been in 2020. In 2022 and 2023, higher interest rates and inflation also cut into consumers' budgets, causing many to rein in their discretionary spending.
It's also naturally difficult for high-growth companies to maintain the same growth rates they previously clocked as they achieve greater scale -- the dollar value of additional sales required to maintain the same percentage growth rate on an expanding base increases each year. That's not always feasible due to market saturation and competition.
SHOP Revenue (TTM) data by YCharts.
Still, the deceleration isn't necessarily a bad thing for a maturing company. Shopify's sales growth isn't in free fall, and the company expects a modest slowdown next year. It's still looking to expand the volume of merchandise sales on its platform by roughly 25%, and it expects to produce more free cash flow than last year, with steady improvement throughout 2024. Its costs are not rising as quickly as its sales, and which is great for a scaling business.
SHOP Free Cash Flow data by YCharts.
Shopify is adeptly managing the transition from a hypergrowth business that's valued based on potential to a faster-than-average growth business with actual profits and cash flows. That's not always an easy line to tread.
The company's competitive position should provide confidence to investors. It developed a slender economic moat, thanks to switching costs, along with its growing scale and strong brand among its target clientele. Despite selling its logistics business, which it had built at significant cost through acquisitions and internal investments, Shopify is still in a position to capitalize on those investments.
Shopify remains partnered with Flexport, the company that acquired its logistics operations last year. That will be a valuable factor as it competes in a crowded e-commerce world that features Amazon and other large-scale retailers with significant digital operations. Don't be shocked if Shopify achieves impressive results over the next few years.
Valuation in perspective
The investment narrative around Shopify ultimately hinges on how its valuation reflects its upside potential. Investors with low risk tolerances probably won't want to get involved -- a lot of hoped-for future success is already priced into the stock, and its expensive valuation ratios increase the likelihood of volatility driven by capital market conditions or even lukewarm earnings reports. That's exactly what happened to the stock in February.
The stock is still worth a look for growth investors. Its forward P/E ratio is actually fairly cheap if the company manages to grow its top line by 20% to 25% with cash flows increasing in the 30% range. That suggests a PEG ratio below 2, and it's tough to find quality growth companies with PEG ratios below 2 right now. This is a stock that's likely to keep climbing if the bull market continues, and the company has the potential to deliver long-term gains even from its current valuation.
