Is It Time to Give Up on Snap Inc. Stock?

Shares of Snap (SNAP +0.00%) recently tumbled to an all-time low after the Snapchat maker posted its third quarter earnings. The drop was initially surprising since Snap beat analyst estimates -- its revenue rose 43% annually to $298 million, which beat estimates by $15 million.

Snap posted a non-GAAP net loss of $325 million, or $0.12 per share, which also topped expectations by $0.15 and represented a significant improvement from its loss of $443 million a year earlier. Its adjusted EBITDA loss also narrowed from $179 million to $138 million.

Image source: Getty Images.

For the fourth quarter, Snap expects 24% to 33% annual sales growth, which matches the consensus estimate for 31% growth. It also expects an adjusted EBITDA loss of $75 million to $100 million, compared to a loss of $159 million in in the prior year quarter.

Snap's headline numbers look decent, but its daily active users (DAUs) slipped 1% sequentially to 186 million. That marked Snap's second straight quarter of DAU losses, and strongly suggests that its user growth is peaking. But did a 1% dip in DAUs justify the 10% decline in its stock price on Oct. 26? Let's dig deeper into Snap's report to find out.

Tracking Snap's DAU growth

First and foremost, Snap's DAU growth clearly decelerated over the past year.

Source: Snap quarterly reports.

That deceleration is often attributed to competition from Facebook's (FB +1.33%) Instagram, which cloned most of Snapchat's popular features, and an app redesign that alienated many users earlier this year. Despite those challenges, 46% of teens still called Snapchat their favorite social media platform in a recent Piper Jaffray survey, compared to 32% for Instagram, 6% for Twitter (TWTR +0.00%), and 5% for Facebook.

Tracking Snap's ARPU growth

Snap also continues to grow its average revenues per user (ARPU) by selling more programmatic ads and integrating more services like product catalogs and streaming shows into its ecosystem. Here's how much Snap's ARPU grew over the past year.

Source: Snap quarterly reports.

Snap's pivot to programmatic ads, which happened at the beginning of 2018, caused a temporary dip in its ARPU, but that rebounded just as its DAU growth peaked. Snap's average ad prices fell, but those declines were offset by advertisers purchasing a higher number of ads. Twitter also employed a similar strategy as its user growth peaked -- which also resulted in a short-term decline in ARPU followed by more sustainable growth.

Therefore, if Snap's DAU growth is merely peaking instead of declining, it can still focus on growing its ARPU with new initiatives like its "Snap Originals" streaming videos, its visual shopping partnership with Amazon (AMZN +0.53%), and its augmented reality "Snappable" games.

Snap and Amazon's visual search feature. Image source: Snap.

Narrower losses and a focus on profitability

When Snap went public last year, it didn't offer investors a roadmap toward profitability. But earlier this year a leaked internal memo revealed that the company had a "stretch goal" to break even in the fourth quarter and achieve full year profitability" next year.

Snap's forecast for the fourth quarter indicates that it won't break even, but its losses are clearly narrowing as it expands its ecosystem and grows its ARPU. Here's how much Snap's losses narrowed over the past year.

Source: Snap quarterly reports.

However, the bears claim that Snap isn't narrowing its losses quickly enough. The company posted a negative free cash flow (FCF) of $159 million during the quarter compared to negative $220 million a year earlier, and its cash and equivalents slid 11% sequentially to $350 million. If the company runs out of cash, it could lead to a secondary offering, which would dilute existing shares.

But it's all about Snap's valuation

I don't think Snap is the dumpster fire some bears see it as. However, my biggest issue with the stock is its valuation: Snap is trading at a 60% discount to its IPO price, yet the stock still trades at 7 times this year's sales.

Twitter and Facebook both trade at roughly 8 times this year's sales, but both companies have bigger user bases and more sustainable top and bottom line growth. Snap simply can't justify that premium with its wobbly business model. I don't think investors should give up on Snap yet, but the stock's valuation offsets many of the company's positive aspects.