The conventional definition of a cheap stock is one with a low earnings multiple. For example, a stock trading for 10 times earnings is cheaper than a stock trading for 20 times earnings.
But as Bob Dylan sings, "The times, they are a changin'." The rising prominence of growth investing supports the idea that it might actually be better to buy a statistically more expensive stock (based on earnings multiple) if its earnings growth suggests that the company will be many times larger in the future. PayPal Holdings (NASDAQ:PYPL) today represents a good example of this theory.
Massive growth potential
PayPal is an online payments company that connects consumers and merchants through its platform, making it part of the infrastructure for the growth of online shopping. For years, it has been the primary payment method on eBay and has recently expanded into partnerships with many other large e-commerce players. It makes its money by charging merchants a fee to accept payment.
Global e-commerce is estimated to be a $2.8 trillion market and has been growing rapidly. PayPal's platform is used in over 200 countries, and it figures to grow as online shopping continues to cut into traditional retail.
The company is also a major player in peer-to-peer (P2P) payments through its Venmo business, which facilitates smaller transactions between friends and merchants. This is a rapidly growing industry because it avoids the fees and the time it takes to send and receive money using banks. PayPal is barely monetizing Venmo today but has several interesting ways to turn this popular platform into a source of profit.
PayPal has experienced strong revenue growth through its prominence in e-commerce and P2P payments, and investors should expect this to continue. The company's most recent guidance implied normalized revenue growth of 18% to 19% for 2019. The cherry on top is that PayPal gets more profitable the larger it grows due to economies of scale, meaning that earnings should grow even faster than revenue.
Valuation vs. other payments companies
A good technique to assess the cheapness of a stock is to compare its valuation ratio with that of its competitors. PayPal's closest competitors are Visa (NYSE:V) and MasterCard (NYSE:MA). They are not exactly in the same business as PayPal -- they are credit card networks while PayPal is a digital payments platform. The distinction is that PayPal is a layer above credit cards; it takes in funds from sources including bank accounts and credit cards.
A look at the relative valuation multiples shows that PayPal trades roughly in line with Visa and Mastercard. But it has historically grown its earnings at a faster rate and is expected to continue growing faster versus its credit card peers. Therefore, there is an argument to be made that PayPal is more attractive on a relative valuation basis.
A five-year look at valuation
Yet another way to value PayPal is to forecast the company's future earnings and then assume a reasonable valuation multiple for those earnings. The table below looks at what PayPal's non-GAAP (adjusted) earnings per share could be in five years based on simple assumptions.
The company has guided for 2019 non-GAAP EPS to come in at roughly $3.15 per diluted share. Assuming that EPS can grow at a 20% rate annually, it will reach $7.84 by 2024. This is a simplified assumption but likely conservative because revenue is expected to continue growing at a high-teens rate, profit margins are expected to continue expanding, and the company is expected to continue buying back stock (bolstering the EPS metric).
After arriving at reasonable estimates for future EPS, investors can apply the earnings multiple they feel is fair. For example, applying an earnings multiple of 20 to the estimated 2024 EPS would imply a share price of $156.80 -- roughly 50% higher than the current price.
There are two important disclaimers here. First, it is impossible to accurately predict what earnings will be several years into the future. Second, it is equally difficult to know the right valuation multiple for a company in the future. That being said, fairly conservative assumptions for PayPal's earnings growth and valuation multiple imply higher share prices, suggesting that PayPal could be undervalued.
Why I bought the stock
I naively assumed that PayPal would be another high-flying tech company trading at an unreasonable valuation. But while its headline valuation multiple is pretty rich, the stock is actually not overly expensive based on its rapid growth. You could argue that the stock is cheap relative to what it will likely earn in five to 10 years.
The payments industry breeds high-quality companies that can produce consistent revenue with high-margin earnings. Once a payment service is entrenched in the minds of merchants and consumers, it becomes a strong consumer brand with a sticky customer base, as shown by Visa and Mastercard. I don't think PayPal is as highly regarded among merchants and consumers as those two, but it's on its way to establishing greater credibility. Along with technological innovation, its rising brand prominence should allow its growth rate to hold strong.