Numbers can lie -- but they're the best first step in determining whether a stock is a buy. In this series, we use some carefully chosen metrics to size up a stock's true value based on the following clues:
- The current price multiples.
- The consistency of past earnings and cash flow.
- How much growth we can expect.
Let's see what those numbers can tell us about how expensive or cheap Paychex (Nasdaq: PAYX ) might be.
The current price multiples
First, we'll look at most investors' favorite metric: the P/E ratio. It divides the company's share price by its earnings per share -- the lower, the better.
Then, we'll take things up a notch with a more advanced metric: enterprise value to unlevered free cash flow. This divides the company's enterprise value (basically, its market cap plus its debt, minus its cash) by its unlevered free cash flow (its free cash flow, adding back the interest payments on its debt). Like the P/E, the lower this number is, the better.
Analysts argue about which is more important -- earnings or cash flow. Who cares? A good buy ideally has low multiples on both.
Paychex has a P/E ratio of 20.3 and an EV/FCF ratio of 16.5 over the trailing 12 months. If we stretch and compare current valuations to the five-year averages for earnings and free cash flow, Paychex has a P/E ratio of 20.9 and a five-year EV/FCF ratio of 17.5.
A positive one-year ratio under 10 for both metrics is ideal (at least in my opinion). For a five-year metric, under 20 is ideal.
Paychex has a mixed performance in hitting the ideal targets, but let's see how it compares against some competitors and industry mates.
|
Company
|
1-Year P/E
|
1-Year EV/FCF
|
5-Year P/E
|
5-Year EV/FCF
|
| Paychex |
20.3 |
16.5 |
20.9 |
17.5 |
| Automatic Data Processing (Nasdaq: ADP ) |
20.0 |
15.5 |
21.3 |
16.6 |
| Equifax |
22.5 |
16.7 |
20.5 |
17.1 |
| Fiserv |
20.1 |
14.7 |
19.3 |
13.7 |
Source: S&P Capital IQ.
Numerically, we've seen how Paychex's valuation rates on both an absolute and relative basis. Next, let's examine...
The consistency of past earnings and cash flow
An ideal company will be consistently strong in its earnings and cash flow generation.
In the past five years, Paychex's net income margin has ranged from 23.8% to 27.6%. In that same time frame, unlevered free cash flow margin has ranged from 27.3% to 29.8%.
How do those figures compare with those of the company's peers? See for yourself:
Source: S&P Capital IQ; margin ranges are combined.
Additionally, over the last five years, Paychex has tallied up five years of positive earnings and five years of positive free cash flow.
Next, let's figure out...
How much growth we can expect
Analysts tend to comically overstate their five-year growth estimates. If you accept them at face value, you will overpay for stocks. But while you should definitely take the analysts' prognostications with a grain of salt, they can still provide a useful starting point when compared to similar numbers from a company's closest rivals.
Let's start by seeing what this company's done over the past five years. In that time period, Paychex has put up past EPS growth rates of 2.1%. Meanwhile, Wall Street's analysts expect future growth rates of 10.2%.
Here's how Paychex compares to its peers for trailing five-year growth:
Source: S&P Capital IQ; EPS growth shown.
And here's how it measures up with regard to the growth analysts expect over the next five years:
Source: S&P Capital IQ; estimates for EPS growth.
The bottom line
The pile of numbers we've plowed through has shown us the price multiples shares of Paychex are trading at, the volatility of its operational performance, and what kind of growth profile it has -- both on an absolute and a relative basis.
The more consistent a company's performance has been and the more growth we can expect, the more we should be willing to pay. We've gone well beyond looking at a 20.3 P/E ratio, and we see that its five-year price multiples are similar to its one-year price multiples -- a sign of Paychex's consistency. It's a similar story at competitor ADP.
We see that the industry has impressively high (and consistent) margins. Paychex, with its focus on payroll services for small- and medium-sized businesses, squeezes even more margin out than ADP. Growth for Paychex has been lower than ADP's but still slightly positive. The initial numbers show slightly premium multiples for a high-quality business model.
As another data point, our CAPS community rates Paychex (and ADP) four stars (out of five). But all this is just a start. If you find Paychex's numbers or story compelling, don't stop. Continue your due diligence process until you're confident one way or the other. As a start, add it to My Watchlist to find all of our Foolish analysis.
I wrote about a stock that's flying under the radar in our brand new free report: "The Stocks Only the Smartest Investors Are Buying." I invite you to take a free copy to find out the name of the company I believe Warren Buffett would be interested in if he could still invest in small companies.
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