PayPal Holdings Inc (NYSE:PYPL) has been one of the biggest winners in this secular bull market. PayPal stock has nearly doubled over the past year. The S&P 500 is up just 20% in that time frame.
Why? The cashless payments revolution. As more and more consumers go digital with their payments, digital payment solutions providers like PayPal and Square Inc (NYSE:SQ) have soared. In other words, the cashless revolution is a rising tide that is lifting all boats in the digital payments space.
While digital payments are hot, mobile payments are hotter. PayPal has a big presence there, too.
And while mobile payments are hotter, Venmo is hottest. PayPal owns Venmo.
Put it all together, and it’s easy to see why this growth stock has nearly doubled over the past year. Can this run continue? I think so. Here’s why…
Why PayPal Stock Still Offers Good Value
It’s not hard to understand the secular growth narrative behind PayPal stock. This is a pure-play on the digital payments revolution.
This revolution has been on fire recently. Paper payments have been fading quickly. No one uses checks anymore, and the number of consumers consistently using cash is quickly diminishing. Meanwhile, e-commerce sales are booming (up 16% in the US last quarter) and all those transactions require digital payment.
Considering how digital payments and e-commerce are inextricably linked, it’s almost a guarantee that the digital payments space will continue to be on fire into the foreseeable future.
In other words, PayPal stock will be supported by a healthy, secular growth narrative for many years to come. That should translate into strong share price appreciation.
Granted, PayPal stock is expensive. It trades at 43 times this year’s earnings on annual earnings growth expectations of roughly 21.5% into 2019. That equates to a 100% growth premium (43 divided by 21.5). The S&P 500 is trading at just over a 75% premium (21.2x this year’s earnings for 12% growth into 2019).
That is a sizable discrepancy in growth premium.
But there are multiple reasons why PayPal stock deserves a bigger growth premium than the market.
First, the company is sitting on a bunch of cash — roughly $7 billion. That is more than 7% of the current market cap of the company, so the balance sheet offers shareholders plenty of protection. That is rare for a hyper-growth company.
The big balance sheet can also be used as a weapon. Management has expressed interest in putting that cash to use via acquisitions and investments. They view themselves as an industry consolidator, and that is good news because this is a booming industry.
Second, PayPal also generates a ton of cash (which, again, is rare for a hyper-growth company). Cash flow grew 34% year over year and PYPL is on pace to have a record year with free cash flow in excess of $3 billion. That would give PayPal stock a free cash flow yield north of 3%.
Better yet, the free cash flow conversion rate is quite high at 26% (they generate $0.26 in free cash flow for every $1 of revenue), so the business model lends itself to generating tons of cash every year. Big cash flow stocks always trade at big premiums.
Third, PayPal is a secular growth narrative with much larger growth prospects in the years to come (2019 and on) than the market. Even if the S&P 500 can maintain its super-charged 12% earnings growth rate over the next 5 years, that would still be well below PayPal’s projected growth rate over the next 5 years (20%).
Bottom Line on PayPal Stock
Overall, despite its big earnings multiple, PayPal stock still offers good value considering its strong balance sheet, robust cash flow conversion rate, big growth potential, and long growth runway.
There will come a time when valuation will wear on PayPal stock — but that time is not now. With the bull market only gaining momentum, and the narrative surrounding digital payment growth only strengthening, PayPal stock will only head higher.
As of this writing, Luke Lango was long PYPL and SQ.