A few days ago (July 30), I made a comprehensive valuation of MasterCard (MA) in which I argued that the stock still had enough upside potential to reach levels of $660 - 670 or more in the next few weeks, from a conservative perspective (while a more realistic scenario would lead us easily to the range of $800 - 830 in a longer span of time); that is, over 12% return in a few weeks and up to 39% return in a longer period of time (MasterCard price at the time of valuation was $597).
After publication (August 1), some people who read my article on MasterCard kindly asked me if I would be willing to do another valuation article on Visa (V) using the same methodology shown in MasterCard's valuation. So this article goes especially to those readers who asked for Visa.
I must say that I have changed slightly my approach this time: in this article I want to go one step further and illustrate which stock is a better investment opportunity.
Just like I did in my previous article, I will divide my valuation into two main sections, which will be broken down to several sub-sections. Nonetheless, for the sake of readability, I will skip some of the argumentation regarding the reasons why I conducted the valuation in the way that I did, therefore if anyone is interested in digging a little deeper, they can simply turn to my previous article and will find it thoroughly explained there.
A. Quantitative valuation
1. Income Statement Method (Valuation using multiples)
Once we have checked that the major players in the Payment card industry (Visa, MasterCard and American Express (AXP)) are indeed comparable, we can proceed with this method.
A very important remark must be made here: Visa's 2012 EBITDA should be a lot higher than it shows (USD 2,472 million), since there is a USD 4,100 million Litigation provision (a very rare item, almost non-existent in 2011 and 2010). In order to make more accurate predictions on income growth (which eventually has an impact on the price of the stock), I have added back the 4,100 million to the EBITDA. Please note that I am not saying that an investor should completely omit the fact that Visa has an extraordinary additional cost of 4,100 million (which certainly is a negative thing), but when making predictions of the future income evolution I believe that is best to omit this infrequent item.
Anyway, for the I.S. Method I 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
PV= EPSV*P/ECompetition= $185.09
b) EV/EBITDA ratio, 7.5% weight
EVV*=EBITDAV*(EVCompetition/EBITDACompetition) = $276.97 per share
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 with a few tweaks more you can easily get the projected price per share.
c) P/Book Value ratio, 7.5% weight
PV = BValueV*(PCompetition/BvalueCompetition) = $264.95
d) P/Dividend ratio, 5% weight
PV = DivpSV*(PCompetition/DivpSCompetition) = $287.06
Sub-section average price: $245.02.
The weight in the final valuation is 30%, for the reasons stated in the previous article.
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 Visa since the company went public in 2008, which is 52.99% annual increase. I have used this rate to estimate the next 4 years (2014-2017).
From the 4th year on, I have used a "long-term" growth rate of 7.223%, 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.
Finally, I gave the obtained rate a weight of 80% and for the remaining 20% I used the growth rate of the GDP of the countries in which Visa operates (preserving the proportion in which each country contributes to the company's net income when computing that average growth rate, of course), which is 3.03% on average for the period 2003-2012.
Let me add here that Visa obtains a substantially larger proportion of its income from the U.S. (46.7%) compared to MasterCard (32%).
The result of this "2-stage" Gordon model is a price per share of $172.91, 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
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 perpetual growth rate of the equity cash flows, whose fundamental assumptions remain unchanged in all 3 scenarios.
For a detailed explanation about how I computed the perpetual growth rate of the equity cash flows, please check the MasterCard valuation article, since I did it in the same exact way (to be consistent).
The result is a 7.21% perpetual growth rate.
Then, it is plain to see that the growth rate used is quite conservative, since Visa's average equity cash flows growth rate in the last 3 years has been about 15%, annually.
What do I change to create a certain scenario? 2 elements: required market risk premium (in the range 6.5%-5.5%), and I multiply the 7.21% 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 University 9 Dauphine) 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: $133.85
- Neutral: $195.42
- Aggressive: $258.68
I gave this method a 60% weight of the final overall valuation, since this 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 $171.11, $208.05 and $246.01, for the "conservative", "neutral" and "aggressive" viewpoints, respectively.
The arithmetic average would be roughly $208 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, 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) = 1.48, which is a good value, which means that current assets are almost 50% more than current liabilities. Ideally, the optimal value should be between 1.5 and 2.
-Cash ratio (Cash/Current liabilities) = 0.26, a good value that means that with the current cash 26% of the current liabilities could be paid, which is the same as to say that the company could spend 26% of the year (just over 3 months) without getting any money from customers and still being able to pay for its current liabilities. The optimal value should be between 0.3 and 0.4.
-Debt ratio (Debt/Assets) = 0.31, again a decent value, which means that debt only finances 31% of all of Visa's assets, the rest is from self-financing (basically, retained earnings). Note that this ratio is slightly worse than MasterCard's (0.42), since it's probably not optimal to finance your business with as little debt: sure the business is presumably "safer", but Visa is paying a heavy cost for it (a lower ROE, which makes the business less attractive to investors). The optimal value should be between 0.4 and 0.6.
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 Z score is 7.04, which basically means that the probability that Visa goes bankrupt is extremely, extremely low (based on the information contained in the audited financial statements of the company). Note that here we don't care that much about the fact that MasterCard's 11.23 Z score is substantially larger than Visa's: from a certain point onwards, an extra 0.01 doesn't make the business any safer (well, maybe just a little, but not much).
I suppose one can imagine the Altman Z score as a square root function relating Z (X axis) with 1- Probability of bankruptcy (Y axis).
- Balanced growth pattern
Theoretically, an ideal balanced growth pattern would be like this:
Net Income growth > Net Sales growth > Assets growth > Debt growth
And Visa's actual pattern is:
Net Income growth > Net Sales growth > Debt growth > Assets 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).
Actually, the truth is that the growth pattern of Visa looks a little better than MasterCard's, since there's only 1 disruption like MasterCard but in Visa it happens at a later point, and plus the disruption is less worrying, since it could actually be a good thing that the company's debt grows faster than its assets (for a limited period of time), since this implies that the Debt ratio is improving (too little debt can be a negative thing, as we discussed before).
2. Porter's 5 Forces for the Payment card industry
The Porter's 5 Forces analysis is essentially the same for the case of Visa as for MasterCard, and so we will remind briefly the main points:
1) Attractive industry: 4 out 5 forces (all except for "rivalry among established firms") drive profitability up for the current players.
2) High barriers to entry preserve profitability for the current players.
3) The legislative pressure on debit and credit card fees is not likely to affect (much) companies like Visa, since although Visa doesn't charge directly the card fees to consumers, the company could pressure the issuing banks to charge a higher annual fee to consumers, and consumers really have not much choice but to pay those hypothetical higher annual fees (provided there's not a new court ruling invalidating such a measure), as the BBC news reported on July 24, 2013.
4) The worldwide drive away from cash
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. Here Visa is at a disadvantage with MasterCard, since the latter company started years ago to build a partnership with China UnionPay (although for now the partnership is not as close as MasterCard would like).
5) Court ruling invalidating the Fed's rule on interchange debit card fees
Bad news for the issuing banks, as well as the card companies, especially for Visa (MasterCard relies less on revenue coming from debit cards than Visa).
In any case, the Fed might appeal the ruling, and therefore the new cap on debit card fees will not be into place (if ever does) in months or years.
6) 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.
7) 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).
Similar to MasterCard, Visa is not willing to miss out on this opportunity: Visa's partnership with Vodafone and Samsung to focus on NFC technology is very promising.
Therefore, there's a decent chance that NFC technology will become tomorrow's most used payment method, and in case that event occurs, Visa (as well as MasterCard) will be in a privileged position to benefit from this technological change.
Conclusion: Visa or MasterCard?
In both cases, the qualitative analysis supports the good results obtained in the "neutral" and "aggressive" quantitative valuation.
However, given the recent strong MasterCard's upside move, I have to say that Visa's short-term price target (under a "neutral" scenario) allows for a larger return than MasterCard's (14% vs. 3.5%).
Nonetheless, Visa's long-term Price Target is less attractive than MasterCard's (23.5% vs. 28.6%), if we compute the long-term PT as an arithmetic average of the neutral and aggressive scenarios for both companies (the conservative scenario doesn't seem likely at all).
In other words, Visa will probably perform better in the short term, but in the long term, we should see larger gains in MasterCard due to its superior growth rate estimate (computed based on an historically superior growth).
Additionally, Visa's financial ratios are slightly worse than MasterCard's.
But, Visa's projected maximum drawdown is a lot smaller than MasterCard's (7% vs. 29%).
In conclusion, Visa's projected share prices under the different scenarios considered show a tighter interval, therefore making it in some sense a "safer" bet than MasterCard right now, but MasterCard does reward for that "additional risk" with an expected larger long-term upside move. And here really comes down to preferences (risk aversion) and all I can say is that if I had to buy one right now, I would perhaps pick Visa (looking at levels of $210, for a nice and quick 14% return) over MasterCard, and then maybe some time down the road, I would sell my position in Visa and open a long position in MasterCard, looking at levels of at least $800.