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Why I think the Afterpay Holdings Ltd share price could zoom higher

On Thursday, the Fairfax Press reported that over the last six months, small cap stocks have slid 5%, whilst their broader counterparts on the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) have eked out a 5% gain during the same period.

According to the article, investors have punished small cap stocks (which generally trade on high price-earnings multiples) for a failure to deliver on potential.

Notable small-cap stocks which were punished over February’s earnings season include vacuum cleaner retailer Godfreys Group Ltd (ASX: GFY) and chocolate maker Yowie Group Ltd (ASX: YOW), both of which plummeted over 25% since the start of February.

Nevertheless, I believe investors in small-cap stocks shouldn’t lose all hope, as some of these little known gems could be the big companies of tomorrow.

Accordingly, Afterpay Holdings Ltd (ASX: AFY) is one stock that’s on my radar for growth potential.

Afterpay’s results

Although Afterpay suffered a 15% fall in value over the month of February, I believe that unlike other small cap stocks, Afterpay’s results and growth prospects justify the company’s lofty market capitalisation of $392 million (as at Thursday’s close of $2.30).

For the first-half of 2017, Afterpay reported revenue from ordinary activities grew a mind-boggling 2,629% to $6 million. The solid result was driven by an increase to retail merchant clients that resulted in underlying merchant sales growing 468% to $145 million.

Importantly, Afterpay’s net transaction margin – the money it makes on merchant fees after transaction cost– increased to over 2.5%. This contributed to the company’s positive operating earnings (EBITDA) of $0.4 million, before one-off costs.

In my opinion, if this growth trajectory can continue, it won’t be long before Afterpay scores its maiden profit.

Touchcorp merger

Another key reason to buy shares in Afterpay is its merger with peer Touchorp Ltd (ASX: TCH).

As announced in late February, Afterpay and Touchcorp have entered into a heads of agreement to form a new holding company (NewCo) via merger. The company will be wholly-owned by existing Afterpay and Touchcorp shareholders in a 64% and 36% split, respectively.

The premise of the merger is so that NewCo can utilise Afterpay’s extensive retail network and Touchcorp’s proprietary payment technology to provide a vertically integrated payment processing solution direct to retail customers.

This, in my mind, could lead to big things.

Foolish takeaway

Obviously the merger between Afterpay and Touchcorp is not without risks. Both Touchcorp and Afterpay are growing technology companies that are yet to prove themselves over the course of many years.

Like investors in Mobile Embrace Ltd (ASX: MBE) and Reffind Ltd (ASX: RFN) have painfully experienced, any missteps in strategy could make things go sour very quickly at this level.

However, based on recent earnings and management’s track record, I’m inclined to back Afterpay as a speculative buy at current prices.

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Motley Fool contributor Rachit Dudhwala has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.