Fool.com: Paychex: What Price Growth? (Fool Plate Special) December 16, 1999

FOOL PLATE SPECIAL
An Investment Opinion

Paychex: What Price Growth?

By Brian Graney (TMF Panic)
December 16, 1999

Payroll processor and small-business human resources services provider Paychex (Nasdaq: PAYX) turned in another impressive quarter of financial results this morning. On a year-over-year basis, EPS was up 36%, total service revenues grew 21%, net margins expanded to 26.6% from 23.5%... yada, yada, yada. If you have followed this company at all in the past, you probably know the drill by heart. For the 34th consecutive quarter, Paychex's earnings are up at least 35% from the prior year period. But despite the Cal Ripken-like growth consistency, investors largely yawned and the firm's shares slipped a tad this morning.

One possible reason behind the pullback could be the company's current price in relation to its earnings, with Paychex trading at about 62 times trailing 12 months earnings and about 51 times forward 12 month expectations. On a straight-away PEG analysis, which compares a company's P/E to its expected growth rate, Paychex appears too rich for any valuation-sensitive investor's blood. Analysts perceive a future annual eanings growth rate of 27%, which is much, much lower than the the current P/E. That makes the stock too expensive, right?

The same, seemingly logical conclusion could have been made by examining Paychex a year ago, when the company's trailing P/E and its expected growth rate
were practically identical to today's levels. Investors relying on the PEG as their valuation tool of choice would have regarded the stock as too pricy at that point in time as well. That would have been a mistake, however, as Paychex has returned 33.1% over the past twelve months with dividends reinvested, beating the 23.6% return of the S&P 500 (of which the firm is a member) over the same span.

While a year is an extremely short period of time in the life of any company, the past 365 days have provided a neat example of how companies with seemingly high valuations can defy traditional valuation logic and outperform the market. Paychex hasn't done all that much to change its business over the past 12 months. Sure, the company's 401(k) plan recordkeeping business is growing like gangbusters, helping to boost human resource services and professional employer organization segment operating income by 138% in the most recent period. But it's not like the company has launched a new Linux intitiative or found the gene that causes some terrible disease.

Most of the outperformance is due to the company's excellent business economics and its ability to provide a return to investors far above its cost of capital. Over the last 12 months, Paychex's net earnings are up 36% but total capital (in this case, shareholders' equity plus long-term liabilities) is up only 29%. Return on average capital over the past 12 months comes in at a stellar 37%. So what the company's seemingly high P/E is really telling us is how highly the market values a company such as Paychex, which is in effect spitting out $1.37 in earnings for every $1 of capital invested in the business. If interest rates and other macro-economic factors stay the same and the company can continue to find ways to expand its business, Paychex's earnings indeed should be worth more than the average S&P 500 company.

Of course, buying the company when its P/E is closer to its growth rate, as Paychex's stock was priced when it traded at a multiple of 42 times earnings in early August, will provide the highest possible return in the end. But just because its multiple is 62 today (which is right in line with its 5-year average by the way, according to Bloomberg) does not mean Paychex cannot outperform the market again in the year ahead. If the past is any guide, interested investors may want to take note.

Related link:
Fool on the Hill, "Why the PEG Doesn't Always Work," 06/19/98