1 Stock That Is Just Too Expensive

What do you get when you mix a wide-moat dividend growth stock with a bull market? The answer to that question is a really, really expensive stock.

Since the beginning of the year, Automatic Data Processing (NASDAQ: ADP  ) has surged more than 28%, besting the return of the S&P 500 Index (NYSEMKT: SPY  )  by nearly 9 percentage points.

SPY data by YCharts.

What's to like about ADP
There's ample reason to like this payroll processor. For one, it's a leader in an industry with an enviable competitive position. The last quarter revealed that more than 91% of its customers stick with the company each year, giving it recurring revenue and the potential to raise prices year after year.

Also, it benefits from a growing tailwind: falling unemployment. As more people go to work, Automatic Data Processing has more paychecks to process, driving up top-line revenue.

Hyperfocus is driving up the stock
One of the reasons ADP is such a high-flying stock is its float. The company has more than $20 billion of customers' money, which it invests in high-rated corporate and government debt to generate a return on its customers' money. Now that higher interest rates are on everyone's mind, investors have big expectations for ADP. If rates go up, then ADP should earn substantially more money on its float.

But there's just one problem: ADP's income from its float is going down, not up. And it now seems this tailwind is more than priced in.

Recent ADP guidance calls for the company to earn just 1.8%-1.9% on its investments in its fiscal year 2014, down 30-40 basis points from 2013. If earnings come in line with guidance, one can expect ADP to generate roughly $2.6 billion in pre-tax income from its investments.

You're probably wondering why it would earn less from its float in 2014 given that rates have actually gone up for much of the last few months. If the 10-year Treasury yield was higher at the end of the fiscal year than the beginning, ADP should stand to earn more from its float, right?

Well, not exactly.

The simple explanation is that ADP's investment portfolio is invested in longer-dated debt securities. Thus, it's still benefiting from higher interest rates before the 2008 financial crisis and subsequent meltdown. So, even though rates are higher today than they were in, say, May 2013, they're still lower than interest rates that ADP locked in before the Fed drove down rates in 2008.

ADP Chief Financial Officer Jan Siegmund had this to add on the company's latest conference call:

"As you see from our quarterly SEC filings, we anticipate less than 10% of the investments will mature in fiscal year 2014, while the maturities in fiscal year 2015 will be more in line with the 15% to 20% range."

Finance that fits on an envelope
If 10% of the investments mature in 2014, and earnings from its float decline by 30-40 basis points, we can surmise that ADP needs interest rates to be 3%-4% higher than they are today to maintain its 2013 level of investment profitability.

What's the likelihood interest rates rise by 3%-4% in 2014, or even 2015? Probably fairly low, especially given that the Federal Reserve still hasn't made the decision to even begin tapering its asset purchases, let alone drive up the federal funds rate.

ADP's smaller competitor, Paychex (NASDAQ: PAYX  ) , may offer a more compelling opportunity. The company has roughly half of its $4 billion average float invested in short-term securities. Thus, when rates move higher, Paychex sees instantaneous movement in its interest income. (Less than 20% of ADP's float is invested in shorter-term, low-yield investments.)

Paychex CFO Efrain Riveria dropped a valuable tidbit of information to investors on the latest conference call, confirming that a 25 basis point increase in short-term rates would add roughly $0.01 to annual earnings per share.

The Foolish bottom line
Rising rates are a catalyst for rising earnings for Automatic Data Processing and Paychex, but this catalyst is already well-known by Wall Street. At more than 20 times forward earnings expectations, neither stock is particularly cheap, given that the S&P as a whole trades for 15.5 times estimated forward earnings.

All in all, Paychex may offer better exposure to rising rates, but investors may be better off waiting to snap it up at less than 20 times forward earnings, a 10%-15% discount to the current price. Both are great brands, but they'll only be great stocks if purchased at the right price.

Find more stocks driven by their float
Many investors are terrified about investing in financial stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

Read/Post Comments (0) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2649445, ~/Articles/ArticleHandler.aspx, 9/29/2016 11:56:20 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,303.53 -35.71 -0.19%
S&P 500 2,166.61 -4.76 -0.22%
NASD 5,295.81 -22.74 -0.43%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/29/2016 11:40 AM
ADP $88.02 Up +0.57 +0.65%
Automatic Data Pro… CAPS Rating: ****
PAYX $57.66 Up +0.16 +0.28%
Paychex CAPS Rating: ****
SPY $216.34 Down -0.31 -0.14%
S and P Depository… CAPS Rating: No stars