When shopping for a bargain, some people turn to online stores that use the Shopify (NYSE: SHOP) platform. But with Shopify shares having fallen 79% in value over the past year, could the company itself represent a possible bargain for my portfolio?
Shopify shares have crashed
The fall in Shopify shares has been dramatic. However, the story here is a familiar one. The share price soared as people spent more time online during the pandemic, then started to fall from its dizzying heights. Although the one-year price chart shows a big dip, if I had bought Shopify shares five years ago, I would have more than doubled my money by now.
Has the decline been overdone, though? After all, the shares now trade below where they stood even at the start of the pandemic. But the business is in stronger shape than it was then. Between 2019 and last year, for example, revenues grew 45%.
How to value Shopify
The company has moved from making losses to turning a profit. Last year, its net income was $2.9bn, although that partly reflected some exceptional items I do not expect to be repeated on the same scale.
Looking at the current profit and loss account is only one way to value a company.
Another approach some investors use is to consider the free cash flows a company is likely to generate and then discount them for the fact that money loses value over time. This is known as the discounted cash flow model of valuation.
Looking ahead, I expect digital commerce to grow in importance. Shopify has been adding merchants In recent years and it is what is known as a sticky platform. In other words, once users have spent the time and effort getting to know it and building their digital shopfront, the switching costs may put them off jumping ship to a competitor. That gives Shopify pricing power.
The gross merchandise volume on the platform in the second quarter was $47bn, representing a compound annual growth rate over the past three years of 50%. The company basically takes a cut of that, so its own revenue is much smaller but still growing.
Shopify has made an operating profit in the past couple of years and I think it has the makings of a scalable, successful digital platform with long-term pricing power. On that basis, the current valuation of $39bn does not look cheap to me but it also does not appear overly expensive given the potential of the business.
Should I buy the shares?
However, potential is one thing – delivering on it can be another. So although I am upbeat about the prospects for Shopify, I would like to see more sustained evidence of its ability to generate a profit.
The company has been making good progress on this front but I would like to see more sustained evidence of profitability. That may mean the shares go up in price again before I decide to buy, but that is a risk I am willing to take.
I like the business model so far but will not be investing in Shopify shares until I feel more confident about the scale of its long-tern profitability prospects.
