Over the course of this week, I have been exploring why I think the Afterpay Touch Group Ltd (ASX: APT) share price is a buy in the first two installations of a three-part series. You can read my previous articles here and here.
Today, I finalise my series by digging a little further into…
Valuation
A company growing at the rate of Afterpay, with legitimate global potential is always going to be extremely hard to value. It will also receive valuations that tend to look absurd on traditional valuation metrics. Based on Afterpay's 2018 financial result of revenue of $142 million and the current market cap of $3 billion, it trades on a market cap/sales ratio of 21 times. Clearly, this would be absurd for many companies. But for a company with the growth potential of Afterpay, this could well be fair value, or even cheap.
How can you value a company that grew its revenue by 390% over the last year and is now entering into new markets that have greater growth potential? I believe that overthinking a short-term valuation for such a fast-growing company, with such a wide range of potential outcomes is futile. To value Afterpay, you must set aside traditional valuation metrics, try and look 5-10 years in advance, and think of how this company may be positioned.
If we look 10 years forward it is easy to see 'buy now, pay later' payment platforms built into nearly all retail online stores.
Before I explain my valuation process I will provide a brief disclaimer:
Beware, the remainder of this article involves a bit of number crunching, so don't worry if your head hurts after reading (mine did too). I am aware that this is a very rough valuation, and many things can change between now and the remainder of the companies global rollout.
The global ecommerce Business to Consumer (B2C) market has grown from $1.3 trillion in 2014, to $2.3 trillion dollars as of 2017 and is expected to grow to $4.5 trillion by 2021 according to Statista's ecommerce report. This is a compound annual growth rate of 19.4%.
This is a trend that does not look like slowing down either with ecommerce sales only making up 10.2% of overall retail sales in 2017 (statista.com). But due to the law of large numbers, you would expect it to slow down at some point. If we take a conservative CAGR of 10% going forward from 2021 out to 2028 we come to a total global B2C ecommerce market of $8.8 trillion dollars in 10 years from now.
China, the biggest ecommerce market in the world currently makes up 29% of the $2.3 trillion market with 2017 annual sales of $672 billion. Because China will probably be the largest contributor to the growing ecommerce market share out until 2028, let's assume they grow their market share to 35%. This is $3.08 trillion. China already has dominant payment platforms like Alipay embedded into their ecommerce market so I think it's unlikely Afterpay will target this market. The well-known government and regulation risks of international businesses operating in China is another reason why Afterpay will probably not go after this market.
So, if we subtract the $3.08 trillion of China's share of the ecommerce market in 2028 from the total addressable market we come to $5.72 trillion.
In the Afterpay business update published to market on September 19, they stated that they estimate that 10% of all physical online retail in Australia was processed through the Afterpay platform. This is a number I expect to continue to increase as they expand their service offering into other verticals such as travel, medical, and beauty which they have started implementing already.
To keep our estimates conservative, we will assume that in 10 years' time they achieve this same 10% of all online sales in the USA and UK.
Based on market share in 2017 the US had $340 billion (14.8%), and the UK had $99 billion (4.3%) of the $2.3 trillion ecommerce market in 2017. If we assume the US and UK maintain their market share proportion in 10 years' time they will offer market size's of $1.3 trillion and $378 billion respectively. The Australian ecommerce market is much smaller and was 10.8 billion in 2017 and is predicted to be 17 billion by 2022 and growing at 5.3% by 2022. By extrapolating 5% growth out until 2028 you get an Australian ecommerce market of 22.8 billion.
This is a combined addressable market for Afterpay of $1,300 billion (US) + $378 billion (UK) plus $22.8 billion (Aus) = $1.71 trillion.
If we assume 10% of these online sales transactions go through Afterpay's platform we get $170 billion of underlying sales processed per year.
A net transaction margin of 2.6%, which is what they achieved in FY18, equates to total revenue of $4.42 billion. Now that market cap of 3.7 billion does not look so silly after all.
If we use a P/S multiple of a similar business, digital payments system PayPal, which earned $13.1 billion in revenue in 2017 and currently trades on market capitalisation of $105 billion. This translates to a P/S multiple of 8. Apply a P/S ratio of 8 to the $4.42 billion predicted 2028 revenue of Afterpay, and you get a market cap of $35.4 billion. This is over 10 times the current valuation of Afterpay today and suggests Afterpay might be cheap.
There is no guarantee that Afterpay will trade on the same multiple as PayPal. I simply used PayPal to compare, as, on the surface, it looks to be a similar business. But even if it was to trade on a lower multiple in ten years' time, the estimated $4.42 billion of future revenue looks extremely cheap at today's price. I have also only included the three markets that they have so far signaled as targets, in Australia, USA, and the UK. It is also likely that Afterpay will enter other regions (already hinted in their investor presentation). Secondly, I have only assumed Afterpay processes 10% of online retail sales which could indeed be much larger as they progress into other verticals.
Foolish takeaway
There are no investment opportunities without risk and in the case of Afterpay, I suggest the future opportunities warrant a case for investment within a diversified equity portfolio.
