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The Shopify sign is seen at its Toronto offices.Fred Lum/The Globe and Mail

Investors who are betting that Shopify Inc. will refute a short-seller's recent negative report had better start hoping the company will also be able to justify the heady valuation of its stock.

Stellar gains since Shopify's initial public offering in 2015 have clearly made the stock an easy target for critics. How else does one explain the remarkable reversal in the share price over the past five days?

Since Oct. 3, Shopify has fallen a total of 22 per cent, including Tuesday's 4.9-per-cent decline, without a a single blip of bad news from the company, its competitors or the economy.

Instead, the skewering follows an unflattering report from Citron Research, a U.S.-based short-seller.

Citron challenged the business model of the Ottawa-based e-commerce software company and questioned the quality of its base of 500,000 customers.

Citron argued that the shares are worth just $60 (U.S.), or about half the price they traded for in New York when the report was released early last week. The shares closed on the NYSE on Tuesday at $92.57. (They also trade in Toronto.)

In response, Shopify has said little, other than to offer some statistics to substantiate its success: More than 131 million consumers have bought from a store using Shopify in the past 12 months; and stores using Shopify have generated $10.7-billion in gross merchandise volume in the first six months of 2017.

Given the decline in the share price, though, investors remain rattled, highlighting one of the dangers in buying highly valued stocks: They can be sensitive to bad news.

The bearish dip in the stock ends what had been a remarkable winning streak for Shopify's share price, which rose more than 600 per cent from its IPO to the start of October. But the spectacular gains have coincided with quarterly losses. And even strong revenue growth has left the shares looking expensive.

Based on revenues over the past four quarters, the shares were valued as high as 20 times sales, or more than 13 times sales using analysts' upbeat estimates for the next four quarters (courtesy of Bloomberg). Consider that the average price-to-sales ratio for the S&P 500 is just two; for the Nasdaq composite index, which is filled with fast-growing technology companies, the price-to-sales ratio is about 2.5.

To be sure, Shopify is a growth stock that appeals to investors who are more interested in betting on its future performance. For them, strong revenues will eventually catch up to the share price.

They may have to be patient. For Shopify's stock to trade at 2.5 times sales – the Nasdaq average – revenues would have to rise to about $4-billion, an eightfold increase from revenues generated over the past 12 months.

The company is going to have to show some inclination to turn a profit, too. It reported a loss of $14-million in the second quarter, ended June 30, the biggest quarterly loss to date. Operating income, which measures profit from a company's underlying business, is also getting worse: Shopify reported an operating loss of $15.9-million in the second quarter.

These numbers are not necessarily fatal flaws. Tesla Inc., which makes electric cars, is also losing money. And Netflix Inc., which sells online movie-streaming subscriptions, is a very expensive stock based on profits and sales. Yet, both companies have rewarded early investors who embraced the underpinning technologies.

Short-sellers often use bluster and hyperbole as they attempt to commandeer the bullish narratives underpinning popular stocks, because that's how they make their money: They profit when shares fall.

Citron founder Andrew Left is no exception to this approach. In his incendiary introduction to Shopify on Citron's website, he said: "A company that hides under the shroud of a cloud-based e-commerce solution for Small and Medium sized Business (SMB), is the promoter of the hottest new 'get rich quick' scheme on the internet."

His allegations could very well be unfounded. But Shopify's rich share price means that the company's journey to vindication could be a bumpy one.

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