Many consumers rightly associate American Express Company (AXP 1.39%) with Mastercard Inc. (MA 0.10%), and it can certainly be argued that there are many similarities. Both companies are in the credit card industry and find themselves well positioned to take advantage of the global war on cash, as more economies move toward a more digitized form of money and commerce. Both companies have also beaten the broader S&P 500 index year to date. Yet, despite both organizations making most of their money within the larger payments industry, the two companies sport two surprisingly different business models, each with their own set of pros and cons. Let's take a closer look at each company to determine which might be the better investment going forward.

A close-up of a blue-colored credit card showing a part of the account number.

Mastercard makes money by acting as a tollway for consumers' money. American Express, in contrast, directly lends money to its cardholders. Image source: Getty Images.

The case for Mastercard

Mastercard makes money by acting as a tollway for consumers' money every time one of its cards or digital products is used to make a transaction. For enabling the transfer of the money from the consumer's bank account to the merchant's, the company collects a tiny fee, usually amounting to a minuscule percentage of the total amount of the transaction. This quickly adds up, however, as Mastercard facilitated more than 18.8 billion processed transactions in its 2018 third quarter.

Since Mastercard merely serves as the tollway for the money, it is not exposed to credit risks, because it is not the entity that actually lends money to the consumer. With Mastercard, as with rival Visa Inc. (V 0.52%), the bank acts as the issuer of the credit. This asset-lite business model accomplishes two things:

  • It gives Mastercard world-class operating margins. In Q3, it sported an operating margin of 59.4%, a number most companies can only dream about. The high operating margin allows for large amounts of money returned to shareholders every quarter. In Q3, Mastercard repurchased $1.2 billion of shares. In addition to buybacks, the company also pays a dividend. While the dividend yield is only 0.55%, it has been consistently raised by double digits every year since 2012.
  • It frees up Mastercard's balance sheet, allowing the company to invest heavily to create supplemental services and products to offer to its financial and merchant clients. These services, accounted for under Mastercard's "other revenues" category, grew to $819 million in the third quarter, an 11% increase year over year.

Thus far, this has been a winning strategy for Mastercard. In the company's third quarter, revenue rose to $3.9 billion, a 17% increase year over year, while adjusted earnings per share grew to $1.78, a 36% increase year over year. Based on its trailing 12 months' adjusted earnings per share (EPS) of $6.08, Mastercard trades at a P/E ratio of about 31.

The case for American Express

American Express, in contrast to Mastercard and Visa, not only acts as the payment highway for funds, but also as the lender to its cardholders. The negative to this business model is that it exposes the company to credit risk. This means that during an economic downturn, when consumers lose jobs and cannot pay their bills, Amex is left holding the bag. This is a risk Amex constantly needs to take into account when approving credit and assigning credit limits. While this risk should not be underestimated, there are two huge benefits to this type of business model -- commonly referred to as a "closed loop" -- one of which is routinely overlooked.

First and foremost, Americans rack up a lot of credit card debt every year, paying huge amounts in interest while this running balance is kept on their cards. As the lender to its cardholders, American Express collects all this interest. In Q3, Amex collected almost $2 billion in net interest income, a 17% increase year over year and good for 19% of Amex's total revenue in the quarter.

Second, this business model gives American Express information about its customers' spending habits and financial transactions that even traditional banks don't have. In the company's third-quarter conference call, CEO Steve Squeri talked about the advantages Amex's closed loop gives the company:

[G]ood credit starts right at the beginning of the funnel, in terms of who you're targeting, who you're letting in, how much money you're lending, and all of that is ... about how we continue to invest in our machine learning capabilities and ... data capabilities and all of that's really powered by the closed loop and ... the data that we have. So it has been a tremendous advantage for us from day one ... So, look, there's many models that are out there in this business ... Our model is unique and the uniqueness is it's integrated, that integration gives you the closed loop, the closed loop gives you the data...

In Q3, adjusted revenue grew to $10.1 billion, a 10% increase year over year, and diluted EPS rose to $1.88, a 25% increase over last year's third quarter. Based on the company's adjusted EPS, shares currently feature a valuation of about a 14.9 P/E ratio.

My final verdict

American Express is cheaper than Mastercard, possesses good brand recognition with consumers and merchants alike, and has a moat based on its network relationship with retailers. There are few companies better positioned to capitalize on the movement toward digitized money, and its unique business model gives it access to data that few companies can match.

That being said, given the choice, I would still rather invest in Mastercard. Because Mastercard is never exposed to credit risks, it will almost always be assigned a higher valuation multiple by the market. The company's revenue and earnings growth are higher and the company is showing real signs of taking market share from competitors due to its investments in its supplemental services, which now range from data analytics and fraud prevention to loyalty program management and consulting.

Mastercard essentially operates as one-half of a duopoly in several key markets, with competition only from Visa, for several of its clients within the world's most developed economies. In addition, it is now competing with Visa and other emerging payments technologies for market share in emerging markets. This gives it several different avenues for future growth. Given its competitive positioning and growth, Mastercard is a prime candidate to be considered for investors' portfolios.