While there are no real winners in the COVID-19 pandemic, some companies are proving the merits of digital operations and growing their businesses at accelerated rates as families shelter-in-place and those employees who can work from home do so. PayPal Holdings (NASDAQ:PYPL) is a prime example. While incumbent digital payment processors Visa and Mastercard shares are still down by double-digit percentages from their all-time highs as they face a sharp near-term slowdown in growth, PayPal is surging to new all-time highs.

To be sure, PayPal's first quarter wasn't perfect. Revenue grew at a subdued 12% year-over-year pace, missing the guidance the company provided at the onset of the year. However, the second quarter is shaping up nicely. Some 7.4 million net new accounts were opened in April, and 15 million to 20 million net new active accounts are expected to be opened in the quarter, and payment volume and revenue increased 22% and 20%, respectively, in April.  

It's clear that PayPal is doing its best to make lemonade of the lemons that the pandemic-battered economy has handed all businesses, and digital payments where a physical card isn't present are getting a boost. A single quarter -- or even a single year -- of stellar performance doesn't necessarily make a company a great long-term investment. Nevertheless, this leader in digital payments, peer-to-peer money movement, and e-commerce is investing heavily for growth, and that's yielding results.

A small shopping cart full of boxes sitting on top of a laptop computer.

Image source: Getty Images.

Investing for the future of banking

The response to COVID-19 is demonstrating that the world of banking and money management has transformed dramatically in recent years. Many consumers and businesses increasingly rely on digital wallets rather than a traditional checking account, and economic activity during the lockdown and subsequent stimulus efforts bear that out. PayPal was approved early on to become a non-bank lender distributing funds under the Paycheck Protection Program (part of the $2 trillion stimulus package that Washington deployed to cushion the pandemic's economic impact). The company said it has already distributed over $1 billion worth in loans into user accounts (which should lead to PayPal earning transaction fees when users make use of those funds), and many people have used either its namesake service or its peer-to-peer money transfer operation, Venmo, as the destination accounts for their stimulus payments, rather than traditional bank accounts. The name of the banking game has changed. 

Beyond increasing the functionality of its money management system, PayPal is also investing in new contactless payment features for vendors, which are likely to be in high demand after more brick-and-mortar businesses reopen and potentially have to adjust to ongoing social-distancing efforts. Leveraging its Honey acquisition will also be key in this area, and cross-selling efforts with the new platform are off to a good start. Honey's active accounts and revenue grew 180% and 40% respectively in April compared to pre-crisis January and February 2020 numbers.   

PayPal's heavy investment in new functions will drag on its profits in the near term, but digital payments have provided big upside thus far. Return on equity has averaged a low-teens percentage rate since PayPal was spun off from eBay in 2015.

PYPL Return on Equity Chart

Data by YCharts.

Ample liquidity, rising profitability

In the short term, PayPal said it is taking a hit on its bottom line due to the coronavirus-driven economic crisis. Earnings per share fell 87% last quarter from a year ago due to the company setting aside extra cash in its credit loss reserves to prepare for a likely surge in defaults.  

Over time, PayPal's operating profit margin has been variable as it spends to promote revenue growth -- even as it has steadily added new users and increased the capabilities of its payment platform. However, free cash flow (a more accurate measure of profitability measured by revenue less cash operating and capital expenses) has been steadily on the rise and notched a 60% increase in Q1 to $1.3 billion.

PYPL Operating Margin (TTM) Chart

Data by YCharts.

Cash flow has been strong enough that PayPal has been able to fund its expansion with little use of debt and buy back shares along the way. The company repurchased $800 million worth of stock during Q1. Cash, equivalents, and short-term investments were $12.6 billion at the end of March, and total debt was $8 billion (including $3 billion drawn down from its credit facility to bolster its reserves). Put simply, PayPal has ample liquidity to maneuver during these uncertain times.  

A not-too-unreasonable premium

As for its valuation, PayPal is currently trading for 39.3 times trailing 12-month free cash flow and 35.1 times forward earnings estimates. That's a steep price tag that both factors in the near-term headwinds affecting the company's bottom line, and also prices in the assumption that PayPal's profits will pick up steam in the not-so-distant future. Now that it has rallied some 50% from the lows it hit in March during the worst of the market meltdown, this stock is up by more than 30% year to date. And it isn't cheap.  

But for investors who plan to hold onto their PayPal shares for at least five years, sitting on the sidelines because of this elevated valuation doesn't make sense. As with all growth stocks, I would advise purchasing PayPal shares in small batches on a recurring basis (like monthly or quarterly), thus building up a larger position over time. This would help mitigate the risk of buying too high and could also offer the opportunity to catch the stock during price pullbacks. 

There are sure to be bumps in the road, especially given the current state of affairs. But the digital payments business that PayPal specializes in was only growing in importance before the coronavirus pandemic, and it looks like it will see a permanent uptick in use as the world adjusts. It's a premium-priced stock worth considering.