Square, Inc. is a tremendously fascinating company. It has played a real role in the democratization of payments systems, enabling small-scale businesses and even solo entrepreneurs the possibility of processing digital payments without having to make significant network purchases.
Additionally, it offers complementary analytics software that provides cumulative and per unit sales data that would have required the use of an accountant’s services and significant time delays even a mere generation ago.
The company is constantly innovative, launching the recent “Cash App” that allows individuals to transfer money among themselves even outside the business context (in a spirit similar to Venmo).
It is deciding to put its data to use, as it has filed paperwork to open a bank in Utah so that it can offer deposit and lending services to individuals and businesses. Given the avalanche of data that it stores, the company would seem well-positioned to start a bank that is much stronger than, say, the typical rural or multi-branch outlet.
If this were the type of business trading at 30x earnings or even 40x earnings, it would offer a compelling risk/reward tradeoff.
The problem? The valuation is utterly obscene compared to where the business is at right now. It is a company that earns $4.5 billion in revenue and loses about $24 million per year (basically, it is spending what it makes).
Even if Square continues to grow revenues at a high double-digit pace, the best case scenario seven or so years from now is that Square might be bringing in $9 billion. If it were to earn typical profit margins for a payment processor and bank, we would be expecting 12% of that $9 billion to flow through to shareholders as net profit. That means, under these favorable assumptions, Square could be earning $1 billion in profit at that time. I should note that these are estimates on the optimistic side of the spectrum, as analysts are collectively calling for between $700 million and $1 billion in profits a decade from now.
Well, over the coming five years, Square is going to be issuing 60 million shares in executive compensation such that the current base of 400 million shares will be at least 460 million. If a company is earning $1 billion in profits spread out among 460 million shares, we would be looking at profits per share of $2.17.
Right now, the stock is at $75. In order for the stock to be worth what the market thinks it is worth now, it would need to trade at a P/E ratio of 34x earnings. For those investors who paid over $100 per share in September? They will need a P/E ratio of over 47x earnings at that time. And that is just for the stock to be worth a breakeven point, let alone any capital appreciation or positive returns.
It is just…so bizarre to me that investors are willing to price companies at rates that require best case scenarios to come to fruition in order for money to be made. As great as Square as, it’s a $30 billion company that is losing money. And it is not losing money in the Amazonian sense of “profits would be here if our capital investments weren’t so high.” Square’s capital spending is only $50 million per year. What you see is what you are currently getting as far as the lack of profitability is concerned.
The “worst-case” scenarios are truly jaw-dropping to consider. I’m not making a prediction that this will happen, but Visa did fall to 15x earnings during the 2008-2009 financial crisis. What happens if 3 years from now, Square is earning $0.30 per share in profits, and trades at a valuation of 15x earnings during a recession? That would be a stock value of $4.50. Again, I’m not offering this as a prediction, but it should be noted as a possibility of what could occur using the closest comparison for something that did occur approximately a decade ago.
There is an old adage: “Hard times create strong men. Strong men create good times. Good times create weak men. And weak men create hard times.” It seems that this principle applies to the stock market as well, as low valuations lead to great returns, the great returns lead to lazily lofty valuations, and the lazily lofty valuations lead to inevitably poor returns. The company might be named Square, but it finds itself at the top of the stock market’s never-ending circle.