Over the past five- and 10-year periods, Mastercard (MA 0.50%) has produced stellar returns of 103% and 584%, respectively. This outstanding performance easily crushes the total returns of both the S&P 500 and the Nasdaq Composite Index. 

But for a business that currently carries a market capitalization of $342 billion, there is a lot that investors simply get wrong when it comes to understanding Mastercard's operations. Here are three common misconceptions you should avoid. For what it's worth, they also apply to the company's chief rival, Visa. 

1. Mastercard takes on credit risk

An extremely prevalent misunderstanding about Mastercard I often see stems from the fact that people think it extends credit, and as a result, takes on credit risk. In actuality, this is what the banks do.

Mastercard has partnerships with financial institutions like JPMorgan Chase, Bank of America, and Capital One, among others, that approve borrowers and then handle these accounts. This means they are influenced by movements in interest rates and the whims of the economy, having to set aside reserves for potential credit losses. 

Instead, Mastercard provides the underlying communications platform that allows merchants and their banks to transfer data with customers and their banks. That's really all there is to it.

The banks do help Mastercard by getting more cards into the hands of more users, which can translate into greater payment volume. The result is that the company simply possesses a less risky business model. In fact, it has posted declining revenue in only one year since 2002, and that was in 2020, when the pandemic ravaged the global economy. 

American Express and Discover Financial Services are a bit different. They both run what are called closed-loop networks, only letting their own branded cards run on their respective payments rails. But they actually issue these cards to customers as well, collecting interest and taking on credit risk. This exposes both businesses to macroeconomic conditions more than Mastercard.  

2. Mastercard receives interchange fees 

A simple credit card transaction has numerous parties involved, all trying to take a cut of the money that moves around. Unsurprisingly, to have the ability to accept card payments, merchants bear the biggest burden, about 2% to 3% of the transaction amount.

Within this, the largest part of the transaction fee by far, called the interchange, actually goes to the card-issuing bank, not Mastercard. Because the banks are the ones taking on credit risk and handling customer accounts, this revenue source could be justified. Plus, interchange fees often help fund credit card rewards programs. 

This is something many people get flat-out wrong. They incorrectly assume Mastercard gets interchange fees, placing blame on the business for hurting merchants. To be clear, Mastercard does set the interchange rates twice a year, so it has some influence over the process. 

However, it collects what is called an assessment fee, which is what Mastercard charges merchants to have access to its card network. Assessment fees are relatively tiny, about 0.13% of the transaction amount. But given that Mastercard processed $8.2 trillion in gross dollar volume in 2022, this can add up. 

3. Mastercard's economic moat is weakening 

The final, and maybe most important, misconception that investors have about Mastercard is that its economic moat is under attack. Mastercard has two primary moats: Its 3.1 billion cards and tens of millions of merchants create network effects. And its capital-light model provides scale advantages. Mastercard generated $10.1 billion of free cash flow last year, good for a 45% margin. 

Nonetheless, the rise of well-known fintech companies, like PayPal and Block, has spooked Mastercard investors into thinking its days of dominance in the payments industry are coming to an end. What's more, the popularity of Apple Pay is also something shareholders need to be aware of.  

There's no doubt that the payments landscape can be very confusing. But I like to think about Mastercard and Visa as the highways, and these newer fintechs as on- and off-ramps to access this highway.

The underlying infrastructure is so ingrained that it would be virtually impossible for a new business to create a payments network from scratch that rivals what Mastercard has built. Also, a valid argument can be made that younger payments companies might actually benefit Mastercard because they further increase the adoption of digital transactions. 

By now, readers should have a much better understanding about Mastercard's business. In fact, this new knowledge might make you bullish about the company and its prospects.