When it comes to Paychex
The company churns out some very impressive returns on equity, it maintains a debt-free balance sheet, and dividend-focused investors are sure to notice the stock's 4.1% yield.
But is the stock worth buying today? Let's take a closer look.
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check on what Wall Street analysts expect and how fast the company has grown in the past.
Annual Growth Rate
|Past 12 months||6.1%|
Source: Capital IQ, a division of Standard & Poor's. Historical growth based on earnings per share.
Analysts still have pretty a optimistic outlook for Paychex's growth, but the company's recent performance hasn't been terribly encouraging. And this shouldn't be all that surprising. Paychex's business depends to a large extent on the number of employees that its clients have, as well as how many small businesses are growing to the point where they need the services that Paychex offers. With the economy faltering and the official unemployment rate near double digits, it'd be really hard to expect the company to be reporting gangbusters growth.
But that's not all. The company also generates revenue from the interest it earns on the funds that it holds for short periods of time for its clients. It doesn't take Alan Greenspan to figure out that when the Federal Reserve is targeting a federal funds rate between 0% and 0.25%, the amount of interest that Paychex can pocket will plummet.
Of course, although these have been pressures on growth over the past few years, they could be boosters going forward if employment starts to pick back up or the Fed decides that it needs to finally start boosting rates to head off inflation.
For my model, I've assumed a top end of 10% growth, which is below the analysts' view but above what the company has produced over the past decade. At the midpoint, I used 8% and dropped it to 5% on the low end.
Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with growth, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.
In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. Right now, Paychex's stock changes hands at nearly 21 times trailing earnings. This may not seem particularly low, but it's on the very low end for Paychex. Over the past decade, the stock has maintained a P/E of above 30 for much of the time, and its lowest point on an average annual basis was 18.
For broader context, we can also look at how similar companies trade.
Heartland Payment Systems
Fidelity National Information Services
Source: Capital IQ, a division of Standard & Poor's.
Although these companies have some similarities to Paychex, with the exception of ADP, they do have different businesses and markets, so it shouldn't be surprising that investors might value them differently. However, I still think it's notable that even if we give Paychex full credit for analysts' growth estimates, it's still among the slowest growers of this group. And even so, the stock's forward P/E of 19.8 makes it the highest-valued stock of the group.
This puts me in a tough position. I don't like to assume that a stock will hang on to an above-market or above-comp-set multiple. However, based on Paychex's trading history (and ADPs), it doesn't seem realistic to assume that investors will suddenly knock the stock's earnings multiple down drastically. So even though it pains me a bit, I set my base-case multiple at 20, while I used 25 and 15 for the optimistic and downside cases, respectively.
Dividends and share count
Our final stop is to consider how much we'll get paid through dividends and whether changes in share count will affect our bottom line.
What worries me about any company's share count is that it will issue a boatload of shares and dilute shareholders. Paychex's share count is down over the past decade thanks to one big share-buyback spree. Lately, the share count has been creeping up slightly, but not enough to be worrisome. It's also notable that the historical growth numbers above are on a per-share basis, so they take share changes into account.
With an attractive current dividend yield, dividends may be a big part of the reason that some investors would look at Paychex's stock. Historically, the company's dividend growth has been pretty impressive, with an annualized rate of 15% over the past decade. But that growth has come as the payout ratio has drastically increased -- from less than 50% 10 years ago to nearly 90% over the past 12 months. That makes me wary of being too aggressive about projections for future dividend growth.
For my model, I set my dividend-growth numbers slightly below the respective earnings-growth numbers for each scenario. I used 8% for the upside case, 5% for my base case, and 3% for the downside case.
The verdict, please!
As for the returns we can expect under the various scenarios, here's what my three outcomes would look like.
Annual Earnings-Per-Share Growth
Annual Dividend Growth
Expected Annual Returns
Source: author's calculations.
Let's now go back to that question that we started with: Could Paychex's stock offer a 100% return?
Under the optimistic case, the answer is "yes." The base case doesn't quite get you there, but the 71% return isn't too shabby, either.
Although base-case returns of 11.3% are nothing to sneeze at, they're slightly below my ideal return target of 12%. Combine that with the fact that I'm a little uncomfortable with the assumptions that I made on Paychex's multiple, and I think I'm going to wait on the sidelines to see whether investors get a little more pessimistic about the stock before I jump in.
Of course, the future is an ever-changing picture, so you need to keep on top of what's going on at Paychex to see which set of numbers the company and stock are able to live up to. And you can do just that by adding the stock to your Foolish watchlist. Don't have a watch list yet? Start one up for free!
The Motley Fool owns shares of Heartland Payment Systems, Broadridge Financial Solutions, and Fiserv and has written puts on Broadridge Financial Solutions. Motley Fool newsletter services have recommended buying shares of Paychex, Automatic Data Processing, and Heartland Payment Systems. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer has no financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.