Better Buy: Visa Inc vs. Paypal Holdings Inc

Image source: Getty Images

It may surprise you to know this, but cash transactions still account for 85% of all global transactions. Americans, accustomed to using our plastic to cover our purchases, don't quite understand the potential that exists for electronic payment systems worldwide.

In today's matchup, we'll pit the largest credit card company in the world-- Visa (V -0.65%), against one of the fastest growing payment companies, PayPal (PYPL -0.40%). While there's no definitive way to divine which company will perform better over the next three years, we'll view each company through three different lenses to get a better idea for which is a better buy today.

Financial fortitude

For investors, cash on hand isn't all that sexy: it doesn't earn much, and is sometimes associated with an unwillingness to return capital to shareholders. But over the long run, cash is always king. That's because when tough times hit -- scandals, industrywide slowdowns, or recessions -- those that have cash on hand have options. They can outspend rivals, return money to shareholders, or even make acquisitions of competitors.

The exact opposite is true of debt -- it can be fragilizing. If a company is caught with too much debt when the economy heads south, it will be forced to go into survival mode. That's a necessary but destructive choice that must be made. Here's how Visa and PayPal stack up in terms of their financial fortitude.

Data source: S&P Global Market Intelligence. Net income and free cash flow are presented on trailing twelve month basis.

It's important to note that Visa is currently valued at roughly four times the market cap of PayPal. Given that, the companies' net income and free cash flow are roughly comparable. That leaves the cash–to-debt side of the equation as the determinant of which company has more financial fortitude.

While Visa is by no means in danger of succumbing to its debt load -- it produces gobs of free cash flow -- it's undeniable that PayPal is in the stronger position. With $4.8 billion in cash on hand versus no debt, PayPal simply has more optionality. It's already used that optionality to buy successful start-ups like Venmo and Xoom.

Winner = PayPal

Sustainable Competitive Advantages

I believe that a company's sustainable competitive advantages are the strongest predictor of its stock's success over the long run. It is through such advantages that any company can put distance between itself and the competition -- allowing returns to compound over decades.

For Visa, the key sustainable advantage is two-fold. For starters, the company owns a 60% global market share of electronic payments. That's a huge advantage, and speaks to the power of both Visa's brand and network. The second major advantage is the company's network effect: with each additional vendor that accepts Visa, individuals have added motivation to use Visa. And with each user that uses Visa, vendors have added motivation to use the company.

But Visa's network effect is in danger of disruption, at the hands of payment systems like PayPal. PayPal allows for a number of different payment options, including taking money directly out of your account like a debit card, or an eCheck. But the fact that you can pay with PayPal via your credit card is where the two companies directly overlap.

In the past, PayPal has been able to offer brick-and-mortar retailers cheaper rates than Visa. PayPal hasn't set up its own credit card processing system -- instead, it uses an existing payment processor's system and pays part of the merchant's cost to use the system, making it cheaper for the retailer. Although they lose money on these transactions, PayPal does it anyway to promote brand awareness and because they can afford to do so. PayPal can afford these losses because almost half of their customers have directly linked their bank accounts to PayPal. Customers use a special PayPal debit card, or use the PayPal app on their smartphone that uses NFC technology to make payments directly from their bank accounts. This lets PayPal transfer money at zero cost to themselves, while bringing in a transaction fee from the brick-and-mortar vendor. This second type of transaction subsidizes PayPal's payments to other credit card processors.  

In the end, the field is changing so fast that it is very difficult to discern who has the stronger competitive advantage. In the face of such opaqueness, I'm going to give the nod to Visa, as it clearly has the strongest brand and network worldwide for non-cash payments. The company's partnership with Apple Pay and its use of NFC technology (via Apple Pay) shows that the company is more the willing to change with the times. But it is with the caveat that Visa's world dominance could change -- perhaps rapidly -- in the near future.

Winner = Visa

Valuation

Finally, we need to look at which company's stock looks like a better deal. There are lots of ways to do this, with four of my favorite below.

Data source: Yahoo! Finance, E*Trade. Non-GAAP earnings used to compute P/E.

Here again we see how difficult it is to find a clear-cut winner. Both companies are valued the same in price-to-earnings. While Visa has an edge when it comes to free cash flow, PayPal looks like a better deal when we take its growth potential into account (via the PEG ratio).

At the end, I think it's best to call this a draw.

Winner = Tie

So there you have it: Visa and PayPal look to be in a dead heat at today's prices. Given that both are focusing on capturing that huge potential in non-cash global transactions -- and both have strong and growing ecosystems that benefit from the network effect -- I think investors would be doing themselves a favor to investigate both for their own personal portfolios. If I had to choose, I would side with Visa, simply because it has a more extensive network.