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…
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