Square Stand

Square's stand reader. Image source: Square.

Square (NYSE:SQ) is finally public, but it's not exactly happy days for the company after pricing shares at $9 for IPO investors, below a previously expected range of $11-$13 per share. After two days of trading the stock is up to $12.70, or a $4.1 billion market cap, still well below the value of its most recent funding round, and a disappointing level for a Silicon Valley IPO.  

Square certainly has challenges ahead and reasons to be skeptical of its business, but the low price may also give investors a reason to look at the upside potential. Here's why I'm interested in this new IPO.

Square Logo

Square's logo. Image source: Square.

Square has real revenue
Unlike Dorsey's other public company, Twitter (NYSE:TWTR), Square has a natural revenue source from its business model and a visible path to profitability. Twitter is trying to shoehorn ads into a social media app that doesn't naturally create concrete financial value for advertisers or users, and that's what's hurt the company lately. But Square is a central part of credit card transactions, meaning money is flowing through its business everyday. No shoehorning a revenue model where it doesn't belong.

Revenue is key for early tech companies because it can give a guide to valuation before companies become more mature and generate consistent profits. If you look at the chart below, you can see that Twitter has traded at a price/revenue ratio in the mid-teens for most of its public life, and when the market realized it wouldn't be able to hit those growth expectations, the stock got crushed. But it still trades for over 8 times revenue today.

TWTR Revenue (TTM) Chart

TWTR Revenue (TTM) data by YCharts.

In the last 12 months, Square has $1.14 billion in revenue and $329.3 million in gross profit (including the $23.3 million in gross loss from the Starbucks deal). It has also grown revenue by 49.9% in the first three quarters of the year -- only slightly less than Twitter's 63.2% growth. 

A market cap of about $4.1 billion gives Square a price/revenue ratio of 3.6 compared to over 8 for Twitter despite comparable revenue growth. Square will have to prove that it can turn revenue into profit, but at the current price/revenue ratio, the downside risk for investors is much lower than a company like Twitter.

IPO disappointment is good for new investors
The media has a tendency to skew benefits of IPO pricing in very confusing ways. An IPO that prices above its range is "successful," and one that prices below its range is a "failure." But remember that we aren't venture capital investors trying to sell at a high valuation -- we're new buyers trying to buy a stock at a value.

Shares trading lower than venture capitalists or Square itself expected is actually good for you and I, and makes the IPO more attractive, not less. Think about that next time you read about what a failure this IPO is. 

Square Reader

Square still has the best looking readers around. Image source: Square.

The "cool" factor is real
The two most talked-about competitors to Square are Intuit (NASDAQ:INTU) and PayPal (NASDAQ:PYPL), and there's no doubt they're far more established in the marketplace than Square. They're also worth $26.8 billion and $44.3 billion, respectively, so that's worth considering when you look at upside potential.

What Square is bringing investors is the "cool" factor in payment processing. If you've ever used Intuit products, you know they don't ooze cool and don't offer the elegant interface Square has. PayPal is a similar offering to Square and will be the competitor to watch, in my opinion.

The cool factor won't make Square profitable, but it does make it an attractive option for hip, young businesses, even if it doesn't offer the same back-end support as Intuit. That's worth something, and Square is clearly attracting a lot of businesses to its platform when you look at its growth numbers.

What Square has to do to be a big winner
Square has the cool factor going for it, and with the "disappointing" IPO, it has a decent valuation for a young growth company. Now it needs to prove to investors it can make money, and it may take some time to do that.

One way to look at value generation is Square's adjusted EBITDA, which pulls out Starbucks' losses and share-based compensation prior to the IPO. On that metric, the company has lost $35.0 million in the first nine months of the year, but that's down from a $57.0 EBITDA million loss a year earlier. And without debt, the company really just needs to have enough EBITDA to pay for capital expenses (the D stands for depreciation) to stay in business. That's a low bar, but one I think Square can easily exceed.

What Dorsey and Square need to prove is that they can turn EBITDA positive quickly and maintain growth at a strong clip. If Square can do both, the stock could be a steal for long-term investors as mobile payments grow. But if it continues to burn through cash, the options are limited for financing the future with a low market cap.

I tend to think the future is bright considering the risk/reward profile. But there are certainly high risks with this investment. Time will tell if this "disappointing" IPO was an opportunity for investors with a long-term horizon, or a sign that the company's challenges are too big to overcome.

Travis Hoium owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends Intuit, PayPal Holdings, and Twitter. 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.