PayPal: Not As Overvalued As Valuation Multiples Suggest

Summary

• PayPal appears to be overvalued when looking at valuation multiples.
• The company generates a lot of cash which boosts its intrinsic value.
• We forecast future cash flows using PayPal's fundamentals.

bizoo_n/iStock Editorial via Getty Images

PayPal Holdings (NASDAQ:PYPL) is a great company that may appear overvalued when looking at valuation multiples. However, it's not as bad as it may appear since the company generates a lot of cash. In this article, we will perform a discounted cash flow analysis to calculate the company's intrinsic value. In addition, we will highlight some important risk factors and growth catalysts that could have an impact on the company's performance.

Valuation

Before we get started on our DCF analysis, it's important to remember that the point of forecasting is not to be precise but to be reasonable. Since our forecast is based purely on company fundamentals, we believe it to be fairly reasonable. To begin the valuation, we need to determine what to consider as growth reinvestment. For PayPal, we consider the following as reinvestment:

• Research and development
• Marketing and sales
• capital expenditures
• Change in net-working capital
• Acquisitions (PayPal is fairly active at acquiring companies)
• Depreciation and amortization (will be subtracted from reinvestment as it is considered maintenance capital expenditures that doesn't contribute to growth)

We take the sum of these expenses and calculate the total as a percentage of revenue.

Next, we will calculate both the revenue to capital ratio and the incremental revenue to capital ratio. The former measures how much revenue the company can generate for each dollar invested. The latter measures the same thing except it focuses on the new revenue generated by new investments. The 5-year averages of each measure are very similar so we set both to 86.5%.

For fiscal year 2021, we will use management's guidance and year-to-date financial statements to estimate margins and growth. However, the reinvestment rate and revenue to capital ratio will be the building blocks of our forecast beyond 2021.

Source: Author

Forecast Assumptions for Growth Phase Pictured Above

• Management expects profitability leverage of 1.05 for each percentage point increase in sales. We arrived at this because the guidance is for a 20% increase in sales and a 21% increase in EPS.
• We kept gross profit leverage flat as it is in line with the historical average.
• As operating margins expand, R&D and marketing become a smaller portion of the reinvestment rate as a percentage of revenue. We also assumed that both expenses as a percentage of operating expenses would revert to the historical average.
• Used historical averages of D&A, capital expenditures, and net-working capital.
• Set acquisition expense slightly below the historical average to be more conservative.
• Calculated the fundamental growth rate for the following year by multiplying the reinvestment rate margin by the revenue to capital ratio.

Source: Author

Forecast Assumptions for Transition Phase Pictured Above

• Assumed revenue growth would decrease in a straight line down to 3% which we used as the terminal growth rate.
• Reduced operating leverage in a straight line down to 1.

Now that we have our forecast, we will plug the numbers into a DCF:

Source: Author using Finbox tools

Assumptions for DCF Pictured Above

• Discount rate: 6.45%
• Terminal growth rate: 3%
• Tax rate: 16.2%
• Half-year convention used

Please note that we grouped acquisition costs with capital expenditures. In addition, we prefer to treat stock-based compensation as a cash expense since it is dilutive to shareholders. For these reasons, the free cash flow for 2021 is slightly below the $5 billion in management's guidance.

As you can see, PayPal is essentially trading at fair value based on our projections.

Risks

Based on our valuation, the main risk for PayPal may be valuation risk. It is currently trading at fair value under current market conditions which include very low interest rates. Therefore, an acceleration to the upside in the risk-free rate or equity risk premium could send PayPal's intrinsic value lower. However, the valuation may be too conservative since PayPal could continue seeing double-digit growth for a long time if they continue to execute well.

Furthermore, acquisitions could be a risk if management overestimates potential synergies or overpays. Few things destroy shareholder value faster than a poorly executed acquisition. Nonetheless, there is little reason to believe that this will be a major issue as the company has a solid track record of acquiring companies.

Growth Catalysts

The company is trying to become a super app to tackle all customer needs. An example is that PayPal introduced purchases with cryptocurrency. Users can instantly convert their Bitcoin, Ethereum, Litecoin, or Bitcoin Cash to US dollars (with no additional transaction fees) that PayPal then uses to complete the transaction. If a merchant doesn't take US dollars, PayPal also converts those dollars into local currency at standard conversion rates set by PayPal. If the company can execute well (which it's likely to do) and continue introducing great features, then it could see stronger than expected growth.

In addition, if inflation were to become an issue that persisted for a long time, then PayPal would be well-positioned to benefit. Higher product prices translate into higher total payment volumes leading to higher revenues.

Furthermore, PayPal also launched Zettle in the U.S., which is a physical card reader. This allows PayPal to take on Square for in-store commerce. This addition helps the company improve its payment ecosystem, making it more likely for merchants who sell both online and in-person to choose PayPal.

Lastly, the company has the resources to continue making strategic acquisitions to further enhance its product offerings. As mentioned earlier, bad acquisitions can destroy shareholder value very quickly. However, great ones can dramatically speed up the value creation for shareholders.

Final Thoughts

PayPal is a great company that appears to be trading at a fair price. If the company continues to execute well, it may indeed exceed our expectations and reward shareholders. Nonetheless, we prefer a higher margin of safety and will stay on the sidelines, for now, while keeping an eye on the stock price.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

Comments

[TJRyan]

Back to $300 that you can bet on...

[SeeAroundTheCorner]

PayPal expects to generate $40B+ in FCFs in 21-25 - see Investor Day Presentation - why do you come in much lower?

[StockBros Research]

@SeeAroundTheCorner Thanks for reading, the numbers are different because as we mentioned in our article, we subtract stock-based compensation and acquisition costs as part of the free cash flow calculation.

Stock-based comp dilutes shareholders.

In addition, acquisition costs seem to be an important part of the company's growth strategy. Therefore, it needs to be considered as capex since that money would not go to shareholders as potential buybacks or dividends.

[SeeAroundTheCorner]

@StockBros Research Got it - that makes sense. Also, your revenue growth forecast decelerates rapidly in the second half of the decade down to 3% exactly when I would expect earnings growth to accelerate as PYPL reaps the benefits of a wide range of investments it is currently making. If earnings growth continues at 20%, the actual valuation is much higher. The way you analyze NPV and decelerated growth - is this typical for Wall Street analysts or this mostly your style?

[StockBros Research]

@SeeAroundTheCorner the way we analyzed is a typical 3 stage DCF model. Since forecasting becomes more difficult the further out you go, it's simply more conservative to "transition" to the terminal growth rate.

But if you have reason to believe the company will continue to grow at 20% during that period then PayPal would be undervalued and you could use our model as a "base" or "bear" case.