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How high can the Xero Limited (ASX:XRO) share price go?

Just over a week ago, Xero Limited (ASX: XRO) announced its acquisition of Hubdoc, yet another in a line of moves that flag the company’s aggressive growth policies.

Hubdoc provides technological solutions to streamline the administrative side of the accounting practice, and has been a crucial part of Xero’s ‘ease of use’ approach to small business accounting. To some, the acquisition was not a surprise, but to others it is another sign that Xero intends to continue the strong growth trend that has characterised the business in recent years.  

Xero has been here before. After peaking at $41.85 in March 2014, the company’s share price slumped to below half of that value on the back of competition from other firms in the sector such as Myob Group Ltd (ASX: MYO).

The retracing has been gradual, but Xero is once again at its pinnacle, and the question now is whether investors are set up for further growth or a similar disappointment.  

Speculation abounds. Most recently, fund manager John Hempton told The Australian Financial Review that the company’s market capitalisation could reach $100 billion in the future. Billion, with a ‘b’.

Whether or not this is hyperbole is a matter of debate. Proponents of the company cite its growth in the USA as a harbinger of huge revenues to come, but others are more sceptical.  

Xero Limited’s Model  

In a recent interview with Commsec Market Analyst, Tom Piotrowski, Xero’s COO & CFO Sankar Narayan discussed the implications of continued growth upon the business’ makeup.

In particular, Narayan pointed to the benefits Xero is seeing from its growth in different markets around the world. Software as a product is somewhat unique, in that all customers are to some extent using the same product.

In theory, this means that all users benefit from the improvement and augmentation of that product as a whole. Narayan points to this as a central reason for the strength of Xero’s platform. The larger it becomes, the better and more attractive its software solutions are to prospective customers. 

Financials  

Xero has delivered a one-year shareholder return of 86.8%, and a 5-year compound return of 24.7%, notwithstanding the company’s turbulent 2014.

The company has recently transitioned to a sole listing on the ASX, ending its listing on the New Zealand Stock Exchange (NZX), which has had a positive effect on the firm’s liquidity; annual turnover was 86% up from 13.4% in the previous financial year.

One-year cashflow growth is up 1,059%, while earnings growth is up 58.6%, indicating a strong move towards profitability for the company, which posted a net loss of $26.2 million for the 2017/2018 financial year.

This company is an example of the limitations of the price to earnings ratio in analysis as even when Xero does post a profit, Commsec forecasts its one-year P/E ratio to be 532.30. 

Foolish takeaway  

Xero is obviously trading on huge expectations that its aggressive growth strategy will pay off in the long run. The question will be whether these huge profits materialise to the degree that the market currently expects.

The answer to this question will depend on the company’s ability to continue to innovate and provide a product to customers that is a serious alternative to other players in the competitive sector.  

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Motley Fool contributor Tom Clelland has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of Xero and has recommended Myob. 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 Scott Phillips.

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