What’s The Downside Risk For Snap?

Snap (NYSE: SNAP) stock has dropped over 20% this year. In fact, the stock has plummeted over 50% from its highs in July last year. It was trading at approximately $8 per share at the close of market yesterday. This recent underperformance can be attributed to lack of second-quarter guidance, concerns about how macroeconomic conditions are affecting advertising demand, and slower-than-anticipated revenue growth, especially in crucial segments. The question now is – could it drop further—another 25-30%? What about 50% to $4 levels?

Well, here’s the concern: even at about $8 per share, the stock isn’t cheap. It trades at close to 35 times its last twelve months’ cash flow. If we invert that number, you get a cash flow yield of approximately 2.9% (ratio of cash flow to price). For context, Meta Platforms trades at just 17 times cash flow. Moreover, Meta is the leader in social networking platforms and has consistently clocked 13% revenue growth over the last few years, compared to 9% for SNAP. Is a 35x multiple truly justified for SNAP?  What you pay, matters. We have constructed the Trefis High Quality Portfolio with an eye toward relative valuation. Notably, HQ clocked >91% return since inception and outperformed S&P, Nasdaq, Dow — all of them.

Image by Souvik Banerjee from Pixabay

Why Is SNAP Expensive?

While Snap’s average revenue growth of 9% over the last three years is modest, and its -13% net margins are worse than most companies in the Trefis coverage universe, there’s a key factor driving its valuation. Snap has significantly expanded its user base, with daily active users climbing from 319 million in 2021 to 460 million currently. This consistent user growth has historically been rewarded by the market.

The company’s appeal to advertisers stems from its primary target audience: younger demographics (Gen Z and Millennials). These groups are highly attractive due to their significant future spending power and engagement with emerging trends, making investors willing to pay a premium for access to this valuable audience.

What’s Next for SNAP?

While Snap may continue to expand its user base in the near term, the critical challenge lies in boosting its Average Revenue Per User (ARPU). This could lead to a slowdown in revenue growth if they are unsuccessful. Furthermore, the company is currently unprofitable, and the imperative to integrate AI into its offerings might further squeeze its already tight margins.

Consequently, Snap’s valuation should align with companies experiencing 5-10% revenue growth, assuming it can even maintain that level.

In stark contrast to Snap, Meta is a more stable, resilient, and profoundly entrenched entity. Its dominance is “embedded” in the fundamental ways people socialize, communicate, and consume digital content. Meta currently trades at approximately 17 times cash flow while delivering 13% annual growth. If Snap were valued at a similar 17x cash flow multiple, its share price would fall to around $4, that is another 50% plunge.

Could Snap’s multiple even dip below the 17x commanded by Meta? Ultimately, the decision of how much you are willing to pay for SNAP rests with you.

Why It May Still Be Okay – And Not A Time To Panic

Snap’s reliance on digital advertising, particularly from sectors like consumer goods, entertainment, retail, and tech services, presents a potential silver lining. There’s always the possibility that advertising spending will rebound. Historically, when economic conditions improve and consumer confidence strengthens, marketing budgets are among the first to expand. This is because companies tend to increase ad spend when they’re optimistic about future sales growth, planning new product launches, or intensely competing for market share.

Should advertising activity and volumes pick up, Snap’s revenues will likely follow suit. There’s a notable pent-up demand from brands that curtailed their advertising efforts during recent economic uncertainties. Crucially, Snap may not need to significantly raise its ad prices; it primarily needs an increase in advertiser activity to drive its revenue growth.

Balancing Risk-Reward

Comparing SNAP with Meta is crucial for understanding the risk-reward profile of an investment in Snap. Effective investment decisions hinge on assessing relative attractiveness. The core question becomes: should you invest in SNAP stock, hold interest-earning cash to avoid market risk, or perhaps opt for an S&P 500 ETF? How much greater is the expected return on SNAP stock compared to cash, and what downside risk must be accepted for that potential gain?

Using a specific “anchor” asset like Meta Platforms offers a powerful framework for evaluating this risk-reward dynamic.

Note: Select comparisons carefully. SNAP is currently a “high valuation” stock. When a company trades at approximately 35x Price-to-Free Cash Flow (P/FCF), anchoring it against Meta provides vital perspective. Meta, trading at more reasonable multiples, often presents a more compelling investment case than Snap.

No matter the trade-off, investing in a single stock can be risky. On the other hand, the Trefis High Quality (HQ) Portfolio, with a selection of 30 stocks, has demonstrated a history of comfortably outperforming the S&P 500 over the past 4-year span. What accounts for this? As a collective, HQ Portfolio stocks achieved superior returns with reduced risk compared to the standard index, with a smoother performance evident in HQ Portfolio performance metrics.

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