The 2023 Winner of the Boston and New York City Marathons Wasn’t Wearing Shoes From Nike or Adidas. She Was in Shoes From This Hot Growth Stock Company. | The Motley Fool

Kenyan athlete Hellen Obiri is taking the long-distance running world by storm in 2023, winning both the prestigious Boston Marathon in April and the New York City Marathon in November.

Obiri worked hard for this moment, so I don’t want it to sound as though her choice of shoe was the determining factor in her victories — it wasn’t. That said, it’s fun to take note of the kicks worn by the winning runner.

In normal years, the winners of the Boston Marathon and the New York City Marathon are wearing running shoes from well-known brands such as Nike, Adidas, Under Armourand Skechers. But this year, Obiri wore shoes from the more obscure brand On (ONON 1.27%)further thrusting the company into the limelight.

Meet the winning shoe company

On is a Swiss company specializing in running shoes. Founded by a runner in 2010, the company focused on designing a shoe that feels like “running on clouds.” The cushioning system it came up with is called CloudTec.

For her part, Obiri was wearing On’s CloudTri 1 shoe for her two major marathon victories this year. But the company has many offerings for athletes to choose from, and it increasingly sells apparel as well.

Growth has been nothing short of spectacular for On. From its founding through 2020, the company grew net sales at an 83% compound annual rate. And growth surprisingly hasn’t slowed much since the company went public in 2021, as the chart below shows.

Data by YCharts.

There are multiple interesting aspects to On’s growth. Through the first three quarters of 2023, direct-to-consumer (DTC) sales accounted for 34% of its total sales. This suggests a high level of brand awareness even though the company is still relatively young.

And awareness is spreading. In its IPO filing, On’s management said surveys show that 75% of its customers recommend its shoes to their friends.

The growing brand awareness and DTC sales are key for On’s business. Direct sales have a higher gross profit margin than the wholesale business. Therefore, as DTC sales grow, the gross margin has opportunity to expand.

Should investors buy On stock?

The first step of investing should be identifying great businesses, and there’s clearly a lot to like with On. It’s a high-growth, profitable company, and the brand is growing in notoriety, which drives DTC sales and higher margins.

However, another step to investing is making sure you’re getting a good value. As Warren Buffett wrote in his 1982 letter to Berkshire Hathaway shareholders, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

Here’s why I think investors should wait for a better price for On stock.

Shoe stocks typically trade at inexpensive valuations whereas On trades at a premium one. That’s fair, given the growth, margins, and potential. That said, it’s also fair to assume that On’s growth will moderate someday, and the market will value it like shoe companies with comparable profit margins.

As the chart below shows, On trades at a premium to Skechers and Crocstwo companies with similar margin profiles. If On doubled revenue and the stock price remained unchanged, its valuation would be cut in half. Even then, it would still be trading at a premium to its peers.

Data by YCharts.

Don’t misunderstand: I’m not saying On is a bad stock to buy because it trades at a premium valuation. I’m saying that On’s valuation could come down within the next five years, for example, and that would be a potential headwind for the stock price. And to overcome this headwind while still providing market-beating returns, it would need to sustain revenue growth at a breakneck pace.

On certainly could sustain the growth, overcoming a falling valuation while still providing market-beating returns. It’s also possible the market will keep On at its premium valuation, further allowing it to deliver outsized returns.

Then again, shoe trends can change quickly, and predicting a stock’s valuation and price is a difficult thing to do.

Therefore, I’d say the balance between risk and reward is too high for most investors when it comes to On stock. It’s an impressive business worth watching, but most investors would be better served by waiting for a better value on this high-flowing growth stock.