To say that PayPal Holdings (PYPL 2.90%) had a difficult 2022 would be somewhat of an understatement. The digital payments behemoth saw its stock tank amid soaring inflation, rising interest rates, and a softer economic environment. Investors are now considering what to do with this top fintech as we enter the new year.
Is PayPal stock a buy right now? Let's take a closer look to find the answer.
Having a strong competitive advantage
While PayPal has created a powerful brand that is recognized as a leader in secure, seamless, and fast digital transactions, I believe the company's greatest competitive advantage is the presence of network effects. Network effects occur when a product or service becomes better and more valuable as more users come on board.
As PayPal brings on more individual users, its payments platform becomes more valuable to merchants because there are an increasing number of potential customers. The flip side is also true. As PayPal adds more merchant accounts, the number of places to shop -- and the utility of being a user -- rises for consumers. This positive feedback loop results in a company that gets stronger over time as it gets bigger.
As of Sept. 30, PayPal counted 432 million total active accounts, including 397 million individuals and 35 million merchants. This represents a 20% increase from the 361 million active accounts the business had just two years ago. Furthermore, the PayPal network processed a whopping $337 billion in total payment volume in the third quarter, with the average account transacting 50.1 times over the trailing 12-month period.
PayPal's focus on digital payments since its founding in 1998 has led it to a dominant position in the industry. According to the company's fourth-quarter 2021 financial update, PayPal's checkout option was available at 76% of the 1,500 largest online merchants in North America and Europe, way ahead of rivals. PayPal has become nearly ubiquitous in the world of e-commerce and cashless transactions.
Things to consider
As of Jan. 3, PayPal's stock traded at a price-to-earnings (P/E) of 38. This multiple compares quite favorably to the stock's average historical P/E of 51. With shares taking a major hit last year, investors are presented with what appears to be a very compelling buying opportunity. Based on 2023 consensus estimates, PayPal's stock sells for a forward P/E of under 16.
There's no doubt that PayPal has exhibited tremendous growth over the years. Revenue and diluted earnings per share have increased at a compound annual growth rate (CAGR) of 18.5% and 25.1%, respectively, between 2016 and 2021. Margins have expanded, and capital expenditures are extremely low. And this has led to strong free cash flow, meaning the business isn't sacrificing the bottom line as it has expanded.
If you want to own the stock, you have to consider what the future might hold. Management will no longer focus on trying to add accounts by any means necessary. Instead, they're opting to bring on higher-value customers that will transact over the network more often, thus resulting in greater per-user fees for the business.
Active accounts are projected to increase by just 9 million (at the midpoint) in 2022, a far cry from the 49 million added in 2021. This might prove to be the right strategy, but investors should get comfortable with active accounts going up a lot more slowly as we look ahead.
One issue I have with the company is that I don't really see much differentiation. Because consumers and businesses have almost no friction when deciding what payments service to use, there aren't any switching costs. For example, a business can accept PayPal for e-commerce sales, as well as debit and credit cards and digital wallets like Apple Pay and Google Pay. And individuals can send money to and receive money from friends and family with Zelle or Block's Cash App, not to mention the number of options out there to buy and sell stocks.
PayPal has certainly dominated and pioneered the electronic payments movement, but competition is fierce right now. And management has pivoted to a slow and steady approach to growth. The stock isn't a buy for me, but those who accept these realities might want to take a closer look.
