Zillow

Image source: zillowgroup.com

Zillow (NASDAQ:ZG) is the market leader in the online real estate space. The Zillow website was launched in 2006 by the founders of Expedia and now has data on over 110 million homes for sale, for rent, and even those not currently on the market. While the stock looks very expensive based on conventional valuation metrics, its scalability and optionality justify the lofty valuation.

Zillow's valuation is high compared to the S&P 500
Zillow currently doesn't produce positive net income and thus doesn't have a P/E ratio. It trades at 10.3 times sales compared to 1.9 for the average S&P 500 company and its price/cash flow ratio is about 10  times greater than that of the average company on the index. This shouldn't pose great concern to an investor looking to put some money into the stock. Great growth companies often exhibit valuations like this early on their lifecycles and investors must pay a premium to get on board early. 

Revenue and earnings growth have been explosive
Looking at the forward PEG ratio, which is P/E ratio divided by earnings growth, shows the potential of Zillow. It is projected to be 0.6 next year. While this is a crude tool, it shows that potential earnings growth more than justifies the lofty forward P/E ratio of 69.4. A company with a P/E ratio of 40 that grows earnings 50% a year might be a "cheaper" stock than one with a P/E ratio of 15 that is only growing earnings 5% a year. 

Zillow has grown revenues from $17 million in 2009 to $387 million for the trailing 12 months (TTM), while increasing gross margins from 76.9% to 90.6% over the same period. Negative net margin is a result of substantial spends on SG&A and R&D, which will both bear fruit for investors in the years to come. 

Scalability is very promising
Zillow identifies two revenue sources in its latest annual report: "We generate revenue from local real estate professionals, primarily on an individual subscription basis, and from mortgage professionals, rental professionals and brand advertisers. Our two revenue categories are marketplace revenue and display revenue."

Signing up local real estate agents to pay a subscription to have access to the platform and to have their "online business card" placed next to customer search queries is a great business. It is a recurring payment and adds to the network effect of the business, wherein the website that has the most customers and the most real estate agents will tend to get more customers and real estate agents.

The more eyeballs that make it to the Zillow.com homepage, the more revenue can be generated from selling advertisements to generate display revenue. Both of these revenue streams depend on it already getting the lion's share of consumer attention. Luckily for Zillow it is the undisputed market leader in the online real estate space. As of January 2015 it was responsible for 36 million unique monthly visitors, while Trulia, which has since been acquired by Zillow, was second with 23 million. No other website had more than 20 million and only two had more than 6 million. The area is consolidating and Zillow looks to be the prohibitive favorite to win the space and the network effect advantages that come along with it.

Optionality presents other future revenue streams
Truly great investments don't always follow the initial roadmap or thesis that investors had when they made their purchase. Motley Fool co-founder David Gardner has written about his early investment in Amazon when it was simply an online bookstore. In 1997, no one could have foreseen it becoming the megaretailer that it has, much less Amazon Web Services, drone delivery, and whatever else is coming down the pike next.

Zillow can be immensely successful doing exactly what it's doing, taking a fragmented market of local real estate agents and consolidating it into a central location that benefits consumers. The true beauty of a great growth investment like this is the possibility of the unknown. Zillow is run by a smart and dedicated management team and I look forward to seeing what levers they may look to pull once the core business is performing like a mature company. Zillow has a lot of valuable information about consumers, a wonderful mobile presence, and a growing footprint nationwide. It will be very interesting to see what kind of company it turns out to be 10, 20, or 30 years from now.

Recent pullback presents a good opportunity for a starter position
Zillow's stock price has taken a hit in the last year, dropping from over $160 in July 2014 to just over $91 now. This presents a great opportunity to buy into a great company that is truly upending the real estate business. Think of it as buying into that great business, which I believe alone justifies the current valuations, and getting all of the future optionality for free.

James Sullivan owns shares of Amazon.com, Apple, and Zillow Group. The Motley Fool recommends Amazon.com, Apple, and Zillow Group. The Motley Fool owns shares of Amazon.com, Apple, and Zillow Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.