Should you buy Xero?

Xero (ASX: XRO), the New Zealand small business accounting start-up, has seen its share price skyrocket by more than 600% in less than a year.

In the last month alone, shares have risen more than 90%, and shares are currently trading at $32.25, making the company a NZ$4.2 billion company, and now fourth-largest stock on the New Zealand Stock Exchange.

And it seems investors just can’t get enough of the disruptive accounting software provider, with the shares up more than 10% today alone. It’s not just investors that are singing the praises of this company either. Heavyweight investment bank Credit Suisse today declared the company the “Apple of accounting”, as it initiated coverage of the company, with an outperform rating and a price target of NZ$45.70, well ahead of the company’s NZ$36.50 share price (for now it seems).

Credit Suisse is the first major investment bank to take a closer look at the company, and declared this was just the start for the company, suggesting it could grow to a $10 billion Nasdaq stock within five years.

Originally founded by well-known New Zealand entrepreneur Rod Drury, Xero counts MYOB founder Craig Winkler as a large shareholder and non-executive director. The company offers low-priced, cloud-based, accounting software for small to medium enterprises, and has no baggage in the form of desktop-based software.

That has given the company a head start on its rivals, including US giant Intuit (NASDAQ: INTU), Sage (LON: SGE) in the UK, MYOB and also Australian company Reckon (ASX: RKN). Xero’s growth has been nothing less than phenomenal. In August this year, the company reported that it had reached a milestone of 200,000 paying customers globally, up from 157,000 at the end of March 2013, 78,000 in March 2012 and just 50,000 10 months prior to that.

On the financial front, the company has yet to report a profit, as it targets reaching 1 million plus customers. Operating revenue is expected to exceed NZ$30.3 million for the six months to September 2013, up 84% over the previous year. Monthly revenue in September 2013 was running at an annualised NZ$70.6 million, showing revenues are climbing strongly. Xero has not stated when it will become profitable, but that may take care of itself as revenues continue to grow, while expenses stabilise.

The difficulty facing investors and analysts is how to value the company. While Xero has yet to hit any major road bumps, it is taking on some significant competitors with deep pockets, while its move into Payroll software will pit the company against even more large and agile competitors. And as with any tech start-up, Xero faces the ever-present prospect of another start-up eating its lunch ala Facebook (NASDAQ: FB) and MySpace.

There’s every indication so far that Xero could indeed grow into a massive global company, with the share price hitting multiples of the current level. But at the same time, there’s also a very high risk that the current share price is massively inflated, and even a small hiccup could see the price plummet like a stone.

Foolish takeaway

Buying shares in Xero is a high-risk punt. In many ways, buyers today are believers in the greater fool (lower case ‘f’) theory. In other words, buying something not because they believe it is worth the price, but speculating that someone will offer to buy their shares at a higher price some day in the future.

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Motley Fool writer/analyst Mike King doesn’t own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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