Shares of payroll processor (and increasingly, human resources specialist) Paychex (Nasdaq: PAYX) defied the continuing slide in the markets today, rising a few percentage points after reporting earnings yesterday evening. I just wish I knew why.

Paychex hardly blew away expectations, after all. Q3 revenue of $532.2 million fell more than a mil short of expectations. Profits of $0.39 per share merely met Wall Street estimates, and management left its previous guidance intact. We're still told to expect high single-digit sales growth in payroll revenue this year, lower-20s growth in HR, and net income about 12% higher than last year. So why are the shares rising on a wave of investor applause?

Results matter
Perhaps investors are beginning to appreciate the business's innate quality, rather than worrying so much about the expectations game. After all, objectively speaking, Paychex did just fine last quarter. Revenue rose 10%, but strict cost controls (operating costs rose just 3%) from this eminently scalable business helped push operating margin up 390 basis points to 39.5% -- far beyond the margins of rivals like ADP (NYSE: ADP), Administaff (NYSE: ASF), Intuit (Nasdaq: INTU), and Hewitt Associates (NYSE: HEW).

And you know what earning better margins on growing revenue means: markedly better profits. Operating income leapt 22% year over year in Q3. Even though declining interest rates hurt the bottom-line results, continued share buybacks concentrated the remaining profits among fewer shares outstanding, helping Paychex to grow its earnings per share by 18%.

The future
We already know that Paychex is sticking with its earlier earnings guidance, but what else can we learn from reading between the lines of yesterday's report? For one thing, I suspect we'll see continued stock buybacks, supported by Paychex's impressive cash-generation capabilities. Free cash flow may not be growing as fast as earnings (it's up 12% year over year through the first three quarters of fiscal 2008), but at $525.8 million for the fiscal year to date, it continues to dwarf what Paychex reports as net income. By my calculations, the company has generated around $607 million over the past 12 months, giving Paychex a price-to-free cash flow ratio of 20.

Hmm...
Which, by the way, tells me I may have been a bit quick to judge Paychex "overvalued" based on its 24 P/E ratio. Relative to analysts' sub-15% long-term profits growth projections, 24 times earnings seems a bit much to pay. But relative to the price-to-free cash flow ratio -- a better measure of cash profitability -- it's a much closer call.

For more on Paychex, read: