Please ensure Javascript is enabled for purposes of website accessibility

Better Buy: PayPal Holdings, Inc. vs. Square

By Matthew Cochrane – Sep 25, 2018 at 4:18AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

These two market darlings seem to be a on a collision course, with new products and services moving each closer to direct competition against the other. So which is the better investment today?

Over the past year, PayPal Holdings Inc (PYPL 1.82%) and Square Inc (SQ -1.94%) have been two of Wall Street's hottest stocks. PayPal, mostly known for its ubiquitous digital wallet platform, has made a series of moves that have bolstered its payment processing services for merchants. Meanwhile, Square, which made a name for itself by making card acceptance easy and affordable for small merchants, is now moving into the world of digital payment platforms for consumers.

These moves look like they're positioning the two companies to become direct competitors with each other more than ever before. Does this increased competition mean the good times are over for shareholders? Which company is better positioned to thrive? Let's take a closer look at each of these two hot fintech stocks to see which makes for a better investment today.

Customer pays at counter with contactless payment via smartphone at a Square Register.

With Cash App, Square is moving into more direct competition with PayPal's core digital wallet platform. Image source: Square Inc.

The case for PayPal

Earlier this year, PayPal made four acquisitions designed to make its omnichannel payment offerings to merchants more robust and attractive. The largest of the acquisitions, iZettle, gave PayPal an in-store processing solution and an increased global presence. At the time of the acquisition, iZettle had a presence in 11 markets where PayPal had thus far been absent.

These moves showed a concerted effort on PayPal's part to truly offer a holistic payments service to merchants. Before these deals, PayPal's Braintree division offered what some considered a best-in-class in-app payment solution, boasting customers such as Uber, but it never had a service that could scale and compete for sellers that needed payment processing at the point-of-sale (POS).

While PayPal is making a focused play for merchants, the network effect of its core payments platform is growing stronger by the day. The company recently announced it had crossed the 250 million active user account threshold. That type of customer base has to look awfully attractive to merchants, making them want to enable PayPal as a method of payment at their website's checkout.

Of course, the more retailers that accept PayPal, the more consumers will want to use the platform...and on and on this self-perpetuating cycle goes. The trend seems to bear out in the company's numbers: In the company's 2018 second-quarter earnings report, active user accounts grew by 15% year-over-year, while payment transactions per active account increased by 9% year-over-year.

This combination of account growth and increasing user engagement is driving impressive top- and bottom-line growth. In the company's Q2, revenue grew to $3.86 billion, a 22% increase year-over-year, its fourth straight quarter of at least 20% revenue growth. PayPal's adjusted earnings per share (EPS) rose to $0.58, a 28% increase year-over-year, representing its fifth straight quarter of at least 20% growth.

To be fair, this growth doesn't come cheap. At its current price and its trailing twelve months adjusted EPS, PayPal shares trade at a P/E ratio of about 42.3. That being said, given its growing network effect, its demonstrated power to consistently grow both revenue and earnings at high rates, and its new focus on additional revenue streams, I believe PayPal's price is more than justified.

The case for Square

While many might only know Square as the credit card reader at their favorite farmer's market stand or food truck, its primary growth driver has been growing out its ecosystem of services offered to small businesses. These services are mostly accounted for in the company's subscription and services-based revenue. In Square's 2018 second quarter, revenue in this category skyrocketed to $134 million, a 127% increase year-over-year -- high even for the lofty expectations spoiled shareholders have for the company. In the company's Q2 shareholder letter, the areas responsible for this category's growth included Caviar, the company's food delivery and mobile order ahead platform for restaurants; Square Capital, the micro business loan platform; and Instant Deposit, the feature that allows businesses and Square Cash App users to access their money instantly. What made this shareholder letter different from past ones is that one new growth driver was also named, something investors had not heard about previously: the Cash Card.

The Cash Card is a debit card linked to a Square Cash App account. The card comes complete with reward points that can be redeemed at select retailers, and give the Cash App many of the same features as a bank account. The addition of the Cash Card definitely seems to be driving engagement for Cash App users: In June 2018, $250 million was spent using the Cash Card, triple the monthly amount that was spent just seven months earlier in December. The strategy was so successful that PayPal quickly adopted the use of its own debit card linked to its Venmo platform.

Square's robust ecosystem makes it much more than a payment processing company offering a commoditized service. Square's collection of services makes it much more likely that its customers will depend on Square for many of their operations, which reduces churn and gives it ample opportunities to cross-sell services to existing clients. In Q2, Square's adjusted revenue grew to $385 million, a 60% increase year-over-year. Not only is that an insanely high growth rate, but it marks the fifth straight quarter of accelerated revenue growth.

If you thought PayPal was expensive, though, prepare for even greater sticker shock this time around. Based on its trailing twelve months of adjusted revenue, Square sells at a price-to-sales ratio of about 28. While that's extremely high, if Square keeps growing revenue at a 60% clip -- or higher -- that will quickly come down.

My final verdict

Before I go any further, in the interest of full disclosure, I should state that I have greater than 5% positions in both PayPal and Square in my personal portfolio. I believe both companies have huge opportunities ahead of them, and will give investors market-beating returns over the long-term. For investors willing to take on more risk, Square's higher growth rates could offer an especially enticing opportunity, especially if its Cash App platform continues to grow and develop a network effect similar to that of PayPal's core platform.

That being said, if I were going to add to one of these positions today, it would be PayPal. I believe PayPal's valuation is fair for its growth, and that the company might be able to quickly grow its merchant base now that it can offer a true omnichannel payments solution.

Matthew Cochrane owns shares of PayPal Holdings and Square. The Motley Fool owns shares of and recommends PayPal Holdings and Square. The Motley Fool has the following options: short January 2019 $80 calls on Square. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.