Shareholders of Zillow would probably like to forget the past six months even happened. The stock dropped 23.1% and now trades at $61.81. This may have investors wondering how to approach the situation.
Is now the time to buy Zillow, or should you be careful about including it in your portfolio? Get the full stock story straight from our expert analysts, it’s free.
Why Do We Think Zillow Will Underperform?
Even though the stock has become cheaper, we're sitting this one out for now. Here are three reasons we avoid ZG and a stock we'd rather own.
1. Revenue Spiraling Downwards
A company’s long-term sales performance can indicate its overall quality. Any business can experience short-term success, but top-performing ones enjoy sustained growth for years. Zillow struggled to consistently generate demand over the last five years as its sales dropped at a 6.6% annual rate. This wasn’t a great result and signals it’s a low quality business.
2. Mediocre Free Cash Flow Margin Limits Reinvestment Potential
Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.
Zillow has shown poor cash profitability over the last two years, giving the company limited opportunities to return capital to shareholders. Its free cash flow margin averaged 11.4%, lousy for a consumer discretionary business.
3. New Investments Fail to Bear Fruit as ROIC Declines
A company’s ROIC, or return on invested capital, shows how much operating profit it makes compared to the money it has raised (debt and equity).
We like to invest in businesses with high returns, but the trend in a company’s ROIC is what often surprises the market and moves the stock price. Over the last few years, Zillow’s ROIC averaged 1.7 percentage point decreases each year. Paired with its already low returns, these declines suggest its profitable growth opportunities are few and far between.
Final Judgment
Zillow doesn’t pass our quality test. After the recent drawdown, the stock trades at 29.6× forward P/E (or $61.81 per share). This valuation tells us a lot of optimism is priced in - we think other companies feature superior fundamentals at the moment. We’d suggest looking at one of our all-time favorite software stocks.
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