Recently I detailed how you might go about thinking about how much you should pay for Visa (NYSE:V). From that commentary came a request for a similar line of thought related to how you might think about valuing MasterCard (NYSE:MA). Interestingly, as impressive as Visa has been, the results from MasterCard may have been even better.
Back in 2006 MasterCard was earning around $0.30 per share as compared to something closer to $3.30 today. The dividend has been increasingly nicely and yet still only takes up a fifth or so of profits. Perhaps most impressive is the idea that from the end of 2008 through 2015, investors would have collected total returns on the magnitude of 32% per annum.
Of course today's investor, or prospective investor, does not benefit from the past growth. Well, they do in that it highlights a solid and growing company, but your future returns are not based on past results. Moreover, as a result of the "carry through effect" the superior performance of the past could very well act as a potential hurdle moving forward.
Still, MasterCard is still set up quite well to be a viable investment in the future. With that in mind, let's think about how you much you might be willing to pay today to partner with the company.
Over the intermediate-term I've seen estimates for MasterCard's growth ranging from 12% to 16%. Let's settle on the lower end and use 13% as our baseline; definitely slower than the company's past, but still an extraordinarily growth rate for such a large company.
Ideally you'd like to think in terms of decades, but for this illustration let's just think about the next five years. If MasterCard was able to grow its earnings by 13% per year, after half a decade you would anticipate a share to have an underlying earnings claim of about $6.20. Next you have to come up with a reasonable valuation multiple.
Over the past decade shares have traded with an average valuation multiple in the low-to-mid 20's; ranging all the way from near 15 during the most recent recession up to almost 30 times earnings in the past couple of years. Let's settle on say 22, remembering that this is merely a baseline to start thinking about the security.
This would imply a future share price of about $136. Next we can add in dividends. Even if the payout grew by 20% per year for the next five years, the dividend still might only make up a third or so of profits. You could anticipate collecting $6 or $7 in per share dividend payments during this period. In total, you might expect a share of MasterCard to generate $142 or so in value in the coming five years.
Incidentally, I believe that this is a crucial first step. A lot of investors look at the price first and then become "anchored" to that value. I personally prefer the other way around - figure out what you think may be reasonable and then check out what is available.
The final step to determine your baseline is to discount that future value back to today. To continue with the illustration perhaps you'd be content with a 9% annualized gain. In doing so you'd come to a "fair value" of $92 or thereabouts. Ideally you'd like to look at a wide range of scenarios, but before we do so let's cut to the punch line.
As I write this, the last quote for MasterCard was just under $94. So our "rough estimate" - and it should be made clear that this is certainly what that was - is more or less reasonable. Today's share price reflects a reasonable return given the assumptions outlined above. You're going to get a down-to-the-penny estimate, but really you want to think in much broader terms.
I'll make two important adjustments to illustrate why this is the case. To create a baseline, I used a discount rate of 9%. Yet that is certainly not to suggest that this is the best or only rate out there. Here's a look at what the same business and share assumptions lead to with different discount rates:
7% = $101
8% = $96
9% = $92
10% = $88
11% = $84
12% = $81
13% = $77
The lower your required return, the higher the price that you're going to be willing to pay. As you can see this gives a fairly wide range - $77 to $106. If you demand a double-digit potential return, based on the assumptions above, you're also going to demand a share price below $90. Alternatively, if you're happy to hold an excellent business with reasonable return prospects you could do so at today's price.
The second item to consider is the potential variability of the business and share price performance. To illustrate this, I'll keep the discount rate the same but change the growth rate and ending P/E ratio assumptions created above:
The top row shows potential growth rates ranging from 6% up to 18%. The first column gives you various ending P/E ratios ranging from 16 up to 30. Obviously scenarios outside of these marks are certainly possible, but I'd contend that they illustrate a good chunk of today's expectations.
The values presented in the cross section of the growth rate and P/E ratio indicate the price that would be required in order to generate a 9% annualized gain. So as an example, if you suspect that MasterCard will grow by 10% annually and later trade at 26 times earnings, the current price of $94 would be expected to generate a 9% yearly return. Alternatively, if you have much higher or lower expectations you can see how the factors play out to influence higher or lower "fair values."
This table gives you a rather wide range - $50 to $150 - which probably isn't helpful in a "should I purchase shares now or wait?" sort of way. However, it does provide a couple of takeaways.
First, it shows you the variability that can exist with a given estimate. A lot of time analysts will come up with a very specific price target, compare this to the current price and make a conclusion. For instance, having a price target of $45 for Wells Fargo (NYSE:WFC) when shares are trading around $49 and concluding it's a "sell." Yet this simultaneously diminishes what we are seeing above. Even a small change in the growth rate, ending valuation or discount rate can have a large effect on the "fair" price to pay.
So it demonstrates the need to keep this sort of flexibility in mind. It's a good thing to come up with a baseline, but it's important not to believe that once you calculate something it is now written in stone. It allows you to put out an intelligent notion like, "I believe that shares are worth around $92 (or $85 to $95), but recognize that there is a good deal of variability that could make this estimate much too high or low."
The second thing that it does, is that it provides you with a sense of what a prudent assumption may look like. Analysts may be expecting 12% or 16% growth, but that doesn't mean that it must formulate. You can see what types of prices would be needed should things not turn out swimmingly. Personally, I prefer to expect a "poor" case and see if things can work out, instead of needing excellent results to support an investment thesis.
In short, determining a "fair" price for MasterCard is not going to be a perfect process. It's not only a math equation. You're going to get a very specific number, but that may or may not eventually be the answer. This is especially highlighted by the demonstration above of what varying discount rates and security performance can mean. The best you can do is come up with a reasonable (perhaps cautious) baseline and then determine a wide range of possibilities so that you're not caught off guard down the line. This gives you a basic idea of what shares might be worth to you, but simultaneously allows for some flexibility in the process.
Disclosure: I am/we are long WFC.
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.