MasterCard: Undervalued By At Least 12.5%, Conservatively

Aug. 1.13 | About: MasterCard Incorporated (MA)

Normally when an investor faces a stock that has been up roughly 1,400% since it went public (May 25, 2006), he or she tends to think that the upside potential may have come to an end, and in most of the cases the investor would be right since with this little information it certainly looks like a price bubble about to burst. However, a little fraction of such cases are not bubbles but well-run businesses like Apple (NASDAQ:AAPL), which is up nearly 1,600% (yes, at today's current price), Amazon (NASDAQ:AMZN), up about 1,200%, Google (NASDAQ:GOOG), up nearly 750%, Grifols (NASDAQ:GRFS), up over 300% in only 2 years, or MasterCard (NYSE:MA), roughly 1,400%.

After a thorough analysis of MasterCard I have found out that this company has not reached its peak quite yet: using a conservative approach, MasterCard is right now undervalued by 12.5%, and perhaps a more "realistic" approach would lead us to staggering figures like 40% or more as I will explain in just a moment.

My valuation will be divided into two main sections, which will be broken down to several sub-sections.

A. Quantitative valuation

1. Income Statement Method (Valuation using multiples)

First of all I would like to stress that this method, although quite popular these days, is often times too simplistic and it can only be used reliably if the companies that will be compared are actually "comparable", and to determine whether the major companies in the industry (that is, MasterCard, Visa (NYSE:V) and American Express (NYSE:AXP)) are really comparable I have based my research on the suggested relevant factors that Dr. Pablo Fernández (PhD in Business economics from Harvard University, and Professor of Corporate finance at IESE) pointed out in several of his academic papers (among others, "Valuation using multiples. How do analysts reach their conclusions", 2002 and "Company valuation methods", 2013).

The conclusion is that those 3 companies are indeed comparable, as most of the relevant factors are sufficiently comparable (Net income, Market capitalization, global Market share, and executive team members). See figure 1 for a chart of the industry market share according to Visa's 2012 annual report.

Payment card industry market share as of september 30, 2012

I have used the following ratios, with the following weights based on Dr. Fernández empirical evidence regarding the usefulness of each ratio when performing a valuation of a company in the financial services industry.

a) P/E ratio, 10% weight

PMA= EPSMA*P/ECompetition= $ 818.75

b) EV/EBITDA ratio, 7.5% weight

EVMA*=EBITDAMA*(EVCompetition/EBITDACompetition) = $ 956.49

In fact with this multiple you obtain the "true" market value of the firm (Enterprise Value), but if we divide this "true" value by the current enterprise value we will get a rough estimate of how undervalued the enterprise value really is, and then if you multiply this factor by the percentage of the enterprise value that corresponds to Market cap (about 95% of EV), and then it follows that each stock of that Market cap is undervalued by that factor, and so all you have to do is to multiply the current price times that factor.

c) P/Book Value ratio, 7.5% weight

PMA = BValueMA*(PCompetition/BvalueCompetition) = $ 273.81

d) P/Dividend ratio, 5% weight

PMA = DivpSMA*(PCompetition/DivpSCompetition) = $ 283.93

Sub-section average price: $ 627.81

The weight in the final valuation is 30%, because on the one hand this method is a quite popular analysts' choice nowadays and on top of that we have argued that the selected companies are (sufficiently) comparable, but on the other hand it's an industry with few big competitors and so the reliability of this method is not as high as it could be if we had more comparable competitors, and for that reason the conclusions drawn should not account for too large a percentage of the final overall valuation.

2. Dividend discount model (modified Gordon model)

Firstly, I call it "modified" because the standard Gordon model has only one growth rate ("g") and I have used two different growth rates: a short-term rate and a long-term one.

The short-term rate is the average compounded annual dividend growth rate for MasterCard since the company went public in 2006, which is 31.13% annual increase. I have used this rate to estimate the next 4 years (2014-2017).

After the 4th year, I have used a "long-term" growth rate of 10.05%, which I have obtained in the following way: I first estimated the growth of the company's expected Equity cash flows using the formula suggested by Dr. Damodaran (PhD from UCLA and Professor of Finance at the Stern School of Business at New York University), which basically is an improved version of the popular ROE*Retention ratio, since this popular version makes an implicit wrong simplification that all free cash flows to equity are paid out to shareholders (as dividends) and this is not true: empirically, according to Compustat database, in 1998 the average dividend to free cash flow to equity ratio across all firms on the NYSE was roughly 50%, meaning that only half of the equity cash flow is actually paid out as dividends to shareholders. Therefore, the resulting rate had to be divided by two to be consistent.

Finally, I gave this rate we obtained a weight of 90% and for the remaining 10% I used the growth rate of the GDP of the countries in which MasterCard operates (preserving the proportion in which each country contributes to MasterCard's income when computing that average growth rate, of course), which is 3.62% on average for the period 2003-2012.

The result of this "2-stage" Gordon model is a Price per share of $ 409.99, which is a very conservative price, in line with what usually is obtained using this model.

Finally, I gave this method only 10% of the final overall valuation weight due to its hyper-sensitivity to the rate "g" chosen: even if it has been thoroughly computed, a slight variation in "g" could lead to a large change in price.

3. Discounted Cash Flows Method

As Dr. Fernández says, "it can be said that, nowadays, the cash flow discounting method is generally used because it is the only conceptually correct valuation method" ("Company valuation methods", 2013).

Having said that, there is no denying that this method, although being the "only conceptually correct" one, relies heavily on the growth rate assumptions that the analyst has to make, although not quite as much as the Dividend discount model.

With that in mind, I did not make 1 growth rate assumption, but 3: I took 3 viewpoints ("conservative", "neutral", and "aggressive"), and then, instead of computing an average value (which would not make much sense), I will leave those 3 possible prices until the end of this analysis, in which I will make a final, overall, valuation taking into account a Qualitative analysis.

In any case, I would say without a doubt that the "neutral" viewpoint is in fact quite conservative, due to the (conservative) way I computed the expected balance sheet & income statement data that I used for 2013, as well as the way I computed the perpetual growth rate of the equity cash flows, whose fundamental assumptions remain unchanged in all 3 scenarios.

In case the investor is wondering how I computed the perpetual growth rate of the equity cash flows, I did it the following way: on the one hand, I used the growth formula suggested by Dr. Damodaran, (which replaces the Retention rate used in the popular version with the equity reinvestment rate, which measures the percentage of net income that is invested back into the firm), and gave it a 30% weight; on the other hand, for the remaining 70% I used the average growth rate of the GDP of the countries in which MasterCard operates, just like I did in the previous method. The result is a 8.38% perpetual growth rate.

Then, it is plain to see that the growth rate that I used is quite conservative, since MasterCard's average equity cash flows growth rate in the last 3 years has been 19.50%, annually.

What do I change to create a certain scenario? 2 elements: the required market risk premium (in the range 6.5%-5.5% based on Dr. Fernández research), and I multiply the 8.38% perpetual growth rate by a factor less than 1, equal to 1 or larger than 1 (although not much larger than 1, based on findings from researchers like Dr. Eric Jondeau (PhD in Economics from Paris Dauphine University) that conclude that stock market returns not only do not follow a normal distribution, but also are not symmetrical, and in fact the negative extremes are more likely).

Then, the prices obtained with each of those viewpoints are the following:

- (Very) Conservative: $ 393.78

- Neutral: $ 731.94

- Aggressive: $ 1272.48

I gave this method a 60% weight of the final overall valuation, since is the method that is considered most accurate by the majority of academia in Finance.

Finally, the overall valuation considering the sub-section prices and its weights gives us an estimated value of $ 465.61, $ 668.51 and $ 992.83, for the "conservative", "neutral" and "aggressive" viewpoints respectively.

The arithmetic average would be roughly $ 710 per share, but, as I said earlier, it would not make much sense since 1) to allocate equal weights to the probabilities of each scenario is arbitrary, and 2) in reality you will not see an "average" of those 3 scenarios, since the "neutral" scenario is already some sort of an average of what is likely to happen.

In the following section, we will find out which of those 3 scenarios seems more likely and why is that, in the light of qualitative analysis.

B. Qualitative valuation

1. Financial Ratios Analysis

a) One-dimensional analysis for the period 2009-2012:

-Current ratio (Current assets/Current liabilities) = 1.91, which is a magnificent value, which means that current assets are almost twice as much as current liabilities.

-Cash ratio (Cash/Current liabilities) = 0.42, an excellent value that means that with the current cash MasterCard has 42% of the current liabilities could be paid, which is the same as to say that the company could spend 42% of the year (roughly 5 months) without getting any money from customers and still being able to pay for its current liabilities.

-Debt ratio (Debt/Assets) = 0.42, again an excellent value, which means that debt only finances 42% of all MasterCard's assets, the rest of the financing coming from self-financing (basically, retained earnings).

b) Multi-dimensional analysis for the period 2009-2012:

- Altman Z score

The Z score has been computed using not only considering 2012, but an average of the period 2009-2012. The results would be even better if only the year 2012 is considered (since is the year with best figures).

Therefore, again I have used a slightly conservative bias in my valuation.

The Z score is 11.23, which basically means that the probability that MasterCard goes bankrupt is extremely, extremely low (based on the information contained in the audited financial statements of the company).

- Balanced growth pattern

Theoretically, an ideal balanced growth pattern would be like this:

Net Income growth > Net Sales growth > Assets growth > Debt growth

And MasterCard's actual pattern is:

Net Income growth > Assets growth > Net Sales growth > Debt growth

Therefore we can conclude that the ideal pattern and the actual pattern are quite similar, and so theoretically the company is having a quite balanced growth (as well as rapid).

2. Porter's 5 Forces for the Payment card industry

See figure 2 for a comprehensive chart elaborated in-house.

PorterClick to enlarge


The Porter's 5 Forces analysis shows us that the payment card industry is rather attractive since 4 out 5 forces (all except for "rivalry among established firms") drive profitability up for the current players. Then, the next logical concern would be to think that if this market is truly that attractive, more companies would get in up until the attractiveness vanishes; however, due to the reasons stated in the above chart, there are high barriers to entry that keep potential players (financial institutions or other payment solutions companies like PayPal) away from this market. Then, following a logical path, it would be reasonable to think that, considering all the arguments presented, the existing firms have incentives to engage in collusive practices… which in any case cannot be too evident or otherwise regulators will intervene in order to preserve market competition, in hopes of protecting the consumer interests (lower prices, higher R+D investments, wider product/service variety, etc).

Speaking of regulatory interventions, last Wednesday (July 24, 2013) the European Commission proposed capping certain fees on credit and debit card purchases; would such a measure have a negative impact on MasterCard? Probably close to 0:

1) This measure is only a proposal from the European Commission: there might be substantial amendments or even being rejected by the Parliament. Moreover, the legislative process can take several years.

2) Even if this law is passed, MasterCard can pass on the cost to consumers, since the company has a strong bargaining position as competition is not very fierce in this industry and so it's not likely that Visa or American Express (MasterCard's only major rivals) will enter a "price war" and absorb the cost derived from that hypothetical new law. Plus, the risk of substitution is negligible. In addition, if Google Wallet accelerates its rate of adoption, maybe precisely through cutting fees to merchants, this cap on fees will not even apply at all.

Therefore, the expected impact for MasterCard is nearly 0.

Other key points

1) Is cash still "king"?

Only in the developing markets and not for much longer: within the last decade, the number of credit cards in the US has been as high as 5 cards per person, and the trend in the developing economies is to switch from cash to electronic payments. As, Ajay Banga (MasterCard's CEO) said in an interview last year, "85% of the world's retail transactions are still in cash, and only 15% are electronic payments but that's changing, and there's a secular move from cash to electronic".

In that direction, it is believed that China's market is extremely interesting: most of the people still use cash; that's where MasterCard comes into play: the firm has reached a mutually beneficial business partnership with China UnionPay (for example, they help MasterCard penetrate in China in exchange for some revenue).

2) The role that social networking sites play

Facebook and other social sites are a great opportunity for the Payment card industry, because when people want to make payments in those social sites, they need a credit/debit card to fuel that account.

3) Mobile banking is the (present and) future

Mobile phones represent the future of payments: the number of people who have mobile phones compared to the number of people who have bank accounts it's multiples (6 billion compared to 2.5 billion). Nowadays, mobile phones can be used as a payment processor provided they are enabled with the required technology (like Google Wallet's NFC technology) and the consumer has a linked card she can use. Moreover, it's also possible to send money by mobile phone (for instance, by using the PayPal app, text message, or the PayPal mobile website).

Digging deeper into this market opportunity, it's essential to highlight that MasterCard is not missing out on this opportunity, and in fact, right now has an excellent strategic position to benefit from the development of this new way of making payments, thanks to the close partnership the company has with Google regarding "Google Wallet", which is a product launched by Google roughly 2 years ago and that has hitherto had a slow rate of adoption basically owing to the fact that at the beginning only the Nexus S was enabled with this technology, but as time goes by more and more devices have this technology, and even there are rumors that the new iPhone 5S (probably to be launched in late 2013) will have built-in NFC technology.

Therefore, if Google is able to win the support of Apple and gets more merchants to join this initiative, there's a decent chance that NFC technology will become tomorrow's most used payment method, and in case that event occurs, MasterCard will be in a privileged position to benefit from this technological change.


The Qualitative analysis does nothing but support the good results obtained in the "neutral" and "aggressive" Quantitative valuation, and therefore I am confident that the true value of MasterCard is currently undervalued by at least 12.5%, as the headline of the article reads, and possibly lays somewhere in between $ 668.51 and $ 992.83, but it would not be sensible to state a certain figure (as an approximation, the average of those two figures is $ 830.67).

However, those figures represent a good approximation to the true value that the company has, not the exact price that the market will eventually trade its shares for, since there is no perfect information and there exist transaction costs, and therefore the market is not fully efficient.

But in any case, the price should approximate the real value, and therefore the margin of error if the valuation has been properly performed is rather small.

Last but certainly not least, the strategy I recommend in order to benefit the most from this investment opportunity is to wait until tomorrow's (July 31) Q2 earnings announcement at 9:00 am ET: if MasterCard beats (again) analysts estimates, I suggest opening a long position in MasterCard through a financial derivative that allows for leverage (like a CFD, for instance), since there's a very high probability of reaching levels of $ 660 - 670 in the next few weeks; if MasterCard falls short, we might witness a pull-back and therefore the price may go down a little bit due to those news, but in any case MasterCard would most likely still be undervalued (at the current price) and therefore would still be a good longer-term investment opportunity.

Disclosure: I am long MA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.