Square (NYSE:SQ) reported fantastic earnings for Q3 on Nov. 5. The outlook now for Square stock looks brighter than ever, especially due to the prospects for its Cash App and its free cash flow (FCF).
As I mentioned in my article on Nov. 4, all eyes were on the profits that its Cash App would produce. Would they now be close to its Seller side (merchant) profits?
Cash App vs Seller Side Profits
The answer is a resounding yes. On page 2 of its shareholder letter, Square has a graph showing its Cash App gross profits (from consumers) were $385 million. Moreover, the gross profits from its Seller side of its business were $409 million.
This means that the difference was now only $24 million. I suspect that in calendar Q4 or possibly Q1 2020, its Cash App gross profits could overtake those from its Seller side.
This was a huge change from a year ago. For example, the Cash App gross profits grew 212% over 2019. By contrast, the Seller side (from merchants) grew just 12%.
Moreover, on pages 8 and 10 of Square’s calendar Q2 shareholder letter, Square said its Seller gross profits were $316 million versus $281 million for Cash App. That was a $35 million difference. But more importantly, the Cash App profits grew 37% quarter-over-quarter, but just 29.4% from the Seller side.
Market Cap Like PayPal
This is very important since it means that Square will have steady growth in its consumer-based transaction revenue. As I pointed out last month, eventually its Cash App profits will dwarf the Seller side profits.
Moreover, this puts Square stock on a glide path to replicate the massive market capitalization of PayPal (NASDAQ:PYPL). As you know, PayPal is a much larger consumer-based transaction revenue company.
For example, PayPal’s market cap is now $274.4 billion versus Square’s $98.1 billion. But Square’s Cash App profits are growing as quickly as PayPal’s. Therefore, over the next three years, we might expect Square to have a similar market cap as PayPal.
That implies a potential gain of 180% (i.e., $274.4 billion divided by $98.14 billion, minus 1.o). Moreover, if this takes just three or so years to occur, the average annual gain could be 40.8% annually over those three years, on a compound basis.
This also means that Square stock is effectively worth $618.36 per share over the next three years (i.e., 2.79 times $221.16, the price on Jan 4, 2021). Even if we discount this by 15%, the present value of Square stock is worth 65.75% of this, or $406.57 per share (i.e., 65.75% x 618.36).
In other words, Square is worth 83.8% more than today.
What to Do With Square Stock
The advantage of what I have just told you is now you have a simple model on how to value Square stock. You don’t really need to rely on various sell-side broker’s price targets. There are other ways to value Square stock.
For example, I considered writing up a free cash flow model to help you see how much Square stock is worth. Or we could do a comparative price-to-earnings, or enterprise-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) model.
But it seems to me that this is simply the easiest way to model Square stock. Watch how fast its Cash App profits are growing. And then, at various points in time, compare PayPal’s market cap in the past when it had similar profits. There is a good chance then that is where Square’s market cap will end up.
Here is a simple way to prove this. In 2018, PayPal made $2.194 billion in operating profits. But after adding back depreciation and restructuring charges of about $1 billion, it made about $3.2 billion in basic operating profits. This can be seen on page 58 of its 2018 annual report.
Square’s run rate of $785 million in quarterly Q3 gross profits from its Cash App and Seller profits equals a run rate of $3.1 billion. So, theoretically, if my model holds up, the two should now have a similar market cap.
Granted, this is a little bit of an apples and oranges comparison. PayPal’s operating profits in 2018 had more expenses than Square’s gross profits this quarter. But the market doesn’t really care about these things. It paints in broad strokes.
Here is the result. At the end of 2018, PayPal stock was at $78.40 versus its recent price of $231.92, or 34% of its present price. That means its $274.4 million market cap was about $93 billion. And voila – that is about where Square’s market cap is today – $98 billion, give or take a few billion.
In other words, Square is on track to replicate PayPay’s huge market value growth. Look out ahead, expect Square stock to at least be 84% higher over the next year or so.
On the date of publication, Mark R. Hake has a long position in Square (SQ) stock.
Mark Hake runs the Total Yield Value Guide which you can review here.
View more information: https://investorplace.com/2021/01/square-stock-could-rise-180-to-catch-up-to-paypal-market-capitalization/