For the year ended May 31, Paychex (Nasdaq: PAYX), the second-largest payroll services company in the country, grew revenue 19% to $869 million. Operating income grew 30% to $336 million, and net income jumped 35% to $255 million. The year was the 10th consecutive year of net income growth topping 30%, and it was the 11th straight year of record sales.

Additionally in its latest year, operating margins jumped to 39% from 36% the year prior, and net margins leapt to 29% from 26%. These margins rival or top those achieved by companies with great business models and execution such as Intel, Coca-Cola, and eBay.

Finally, return on equity at Paychex has been a strong 38%, and the company's free cash flow (which is operating cash flow minus capital expenditures) has grown, on average, at a rate near equal to operating income growth.

       Free Cash Flow     Annual Growth
1997    $89.0 million     N/A
1998   $108.6             22%
1999   $152.0             40%
2000   $216.1             42%
2001   $259.7             20%

Steady gains in free cash flow indicate that the growing revenue and operating earnings at Paychex are not just "show" resulting from more expensive efforts. Instead, the additional revenue and earnings are achieved simultaneous with contained expenses, resulting in more cash flowing directly to the company's bank account. In other words, economies of scale (or efficiency) make each new dollar of revenue less expensive to obtain.

Paychex's balance sheet has grown stronger year by year. As of August 31, cash and investments totaled more than $650 million, up from $460 million the year ended May 31, 2000, and $300 million the year before that. The company's long-term debt is zip. Financially, Paychex is on very strong ground and its business performance since 1980 is about one in a million. Literally.

But we haven't decided to buy it yet. We wouldn't buy the best house in the world at any price, but only at a fair price -- a price that should create good value for us in the long run. Price watching has been our discipline since our beginning. So, "What price Paychex?"

Paychex's valuation
Perhaps the most worthwhile way to measure a company's price tag is to consider its enterprise value to free cash flow. Enterprise value is a company's market capitalization (shares outstanding times share price) minus the cash and equivalents on hand, plus the company's long-term debt. You add debt and deduct cash because that gives you the net cash that another company would pay to buy the company (because the acquiring company would also acquire the cash and debt in a buy-out).

With 375 million shares outstanding and a recent share price of $30, Paychex has a market capitalization of $11.25 billion. Subtracting its $650 million in cash and equivalents, the company's enterprise value is $10.6 billion. Its free cash flow for the full year recently ended was $260 million. So, Paychex at $30 trades at 40.7 times its free cash flow. (It's at 43 times trailing earnings.)

For a company that has grown net income and free cash flow 36% on average the past five years, a 40 multiple on free cash flow is not much of a premium. The share price is driven most by future expectations, however, and Paychex said last month that this year net income should only grow approximately 20% on a 13% to 15% rise in sales. The stock trades at 37 times the $0.80 per share estimate for the year ended May 2002. That -- 37 -- is a pretty aggressive multiple to 20% growth.

The company's P/E range the past five years (from has been:

           2000   1999   1998   1997   1996
High P/E   120     80     88     75     83  
Low P/E     47     42     48     37     39

So, yes, 37 is the low of the range the past five years. Of course, though, we must consider that the past five years were one of the strongest bull markets in history, and Paychex was growing income 36% annually. Now the stock market is much less generous and Paychex is set to grow earnings 20%. That type of consistent high-growth coupled with sustainable business advantages still deserves a premium valuation, arguably a P/E of between 25 to 40, depending on how weak or strong the stock market is.

If we believe that Paychex can meet its new much lower goals, and that it won't fall below a P/E of 25 the next few years, the downside risk here is about 33%, to $20 per share. The upside potential for the stock, however, appears quite limited (the stock is already bumping into a P/E of 40) for at least the next few years. That is, the upside is likely limited unless Paychex outperforms expectations.

What's wrong, anyway?
Part of the reason that net income is dropping from 36% annual growth to projected 20% growth this year is that interest rates are at their lowest point in forty years, and Paychex earns significant income ($83 million in revenue last year, or nearly 10% of total revenue) on interest earned on client money withheld for taxes. This income dissolves whenever interest rates and tax rates decline. Additionally, the weak economy means fewer small companies to cozy up to for new business, and fewer employees on payroll.

The positive side of this coin is that interest rates are more likely to rise in the intermediate- and long-term future from their current 2.5% rather than continue to decline, and Paychex will benefit with each tick upward. Additionally, I believe the economy is likely to be much stronger five years from now (or even three years from now), and Paychex should benefit via more clients and more people employed.

In summary, Paychex is a strong business that is built to last and prosper, trading at the low end of its historical price to free cash flow and earnings because growth has slowed from 36% to 20%. Growth may never be 36% again, but it could be 25%, say, or more, when factors relevant to Paychex work in its favor again. So we have a high-growth stock with downside risk that appears reasonable, while significant price appreciation in the next few years will likely occur only if interest rates and the economy start to uptick. How likely is that? I believe the economy will improve sooner rather than later, but what I (or any individual) believe is worth squat when you get down to it. The world is too unpredictable. So, we need more information to add to our decision making.

Next week we'll run a discounted cash flow model on Paychex to give us more parameters to ponder regarding its valuation and possible future value.

P.S. The Motley Fool is changing data providers for its portfolio numbers, and meanwhile Drip Port's numbers (usually below) are not available. Thank you for patience.

Jeff Fischer owns the stocks in the Drip Port, but not Paychex. The Fool has a full disclosure policy.