In my article about the ETFMG Prime Mobile Payments ETF (IPAY), I discussed some of the top holdings, including PayPal (PYPL), Square (SQ), Visa (V), and Mastercard (MA). Out of the four, I believe PayPal has the best outlook moving forward, though the others are primed for the digital payments industry growth as well. All of PayPal’s financial figures that I cite in this article are from its 2020 Q2 Investor Updates and Results filings.

PayPal primarily makes money from transaction fees from its merchant sellers. They setup online payment systems with PayPal and PayPal takes a cut of every transaction. This setup means consumers must also have a PayPal account, which also means every transaction requires at least two active PayPal accounts. This two-sided network is a competitive advantage for PayPal, as noted by CEO Dan Schulman.

PayPal also makes money in its Peer-to-Peer (P2P) segment with users sending each other payments via PayPal or Venmo. There are over 40 million Venmo users in the U.S., which is about 20% of the over 18 U.S. population. PayPal can receive transaction fees for faster transfers to bank accounts. It also receives interest on money left in accounts. This can quickly add up as U.S. consumers on average leave $485 in their PayPal accounts vs. just $196 in their wallets.

Record Performance in Q2

Paypal Q2 2020 record

paypal account increase

Source: PayPal 2020 Q2 Investor Update

PayPal has experienced record growth as a result of the pandemic. Merchants who were unable to continue in-person sales moved online. This lead to 21.3 million total new accounts with 1.7 million new merchant accounts added in 2020 Q2.

tpv paypal

Source: PayPal 2020 Q2 Investor Update

Total Payment Volume (TPV) grew 30% despite a ~60% drop in verticals most affected by the pandemic. This shows that while PayPal is hurt in some sectors by the pandemic, it was able to more than recover the losses from the massive increases in e-commerce transactions, in general.

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Most importantly, PayPal was confident enough in the performance of the most recent quarter and future trends to raise guidance for Q3 and also the fiscal year. For fiscal year 2020, PayPal now expects to see a 22% YoY growth in revenue and 25% growth YoY in EPS.

Since PayPal concentrates most of its business to online merchants and digital P2P payments, it was less affected than some of its peers. Square saw a 17% decline in revenues in its seller ecosystem business which primarily targets in-person sales at small businesses which is a segment most affected by the pandemic. However, in contrast, its CashApp business, a competitor to PayPal’s P2P services, saw massive growth similar to PayPal. Visa (NYSE:V) and Mastercard (NYSE:MA) also faced headwinds as much of their business is also via in-person transactions (card present). Visa reported a 50% decline in April and 20% decline in May YoY in in-person transaction volumes.

A Leader In Digital Payments

PayPal was founded as a digital payment company, initially as part of the eBay (NASDAQ:EBAY) platform but later spun off to accomplish even greater reach. In my article on IPAY, I argue that the digital payments industry will be significantly accelerated by the pandemic. PayPal is still one of the leaders of this industry and committed to staying there. CEO Dan Schulman affirms this, saying:

In the midst of the COVID-19 pandemic, digital payments have become more important and essential than ever. Our record performance in the second quarter – our strongest quarter ever – reaffirms the relevance of PayPal in the unfolding digital future. We’re committed to supporting our consumers and merchants as they work to safely navigate this new reality.

Valuation

ChartData by YCharts

PayPal has had a significant run up since the pandemic began, both in price and P/E ratio. The current P/E ratio is about 88x which is relatively high compared to the current S&P 500 ratio of 28x. Visa and Mastercard are hovering around 40-45x. Square’s ratio has skyrocketed recently and sits above 200x. PayPal’s valuation certainly is not cheap, but similar to Square, it is priced for growth. The question is, can it achieve the expected growth?

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ChartData by YCharts

Since 2016, PayPal has consistently grown EPS, doubling EPS from about $1 to $2.07 in 4 years. This is about a 20% CAGR. PayPal raised guidance for fiscal year 2020 to 25% EPS growth and I believe the future for digital payments is solid. Let’s assume PayPal can continue to grow EPS at 20% annually on average for 5 years. This means in 2025 PayPal will have an annual EPS of $5.15. The current price as of the publication of this article is $192.80. Let’s go through a few P/E ratio possibilities in 5 years and what the expected annualized ROI would be.

Scenario P/E Future Price Annual ROI
Maintain Current P/E 88 $453 19%
Historical Average 55 $283 8%
V/MA Average 40 $206 1%
S&P 500 Average 28 $144 -6%

The expected annual ROI is only significant in the “Maintain Current P/E” scenario with 19% annual ROI. It’s questionable that PayPal can maintain this level of P/E ratio in 5 years as companies typically mature over time and no longer grow as much as they used to.

Taking a more conservative approach is to look at PayPal’s historical average, which is 55. This would lead to an 8% annual ROI, which is roughly the market average return. I see this as the worst-case estimate for PayPal.

I do not think that PayPal will be priced with similar P/E ratios as Visa, Mastercard, or the S&P 500, which would result in very low or negative ROI. PayPal is a leader in the industry and less exposed to the current macroeconomic risks compared to Visa and Mastercard. Additionally, even in 5 years, I expect it to have higher growth prospects than the average company in the S&P 500 given its technological focus.

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Conclusion

PayPal is a strong player in the digital payments industry and the pandemic will only accelerate its growth. Its current valuation, however, is at near record high levels. If you believe PayPal can continue to maintain its current P/E ratio and growth rates, it’s certainly a great buy.

I plan on continuing to invest in PayPal via the diversified digital payments ETF, IPAY, as it is one of the top holdings. At PayPal current valuation, I am not comfortable holding it as an individual stock in my portfolio which would overweight it.

Disclosure: I am/we are long IPAY, SQ. 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.

Additional disclosure: I am not a financial advisor. All recommendations here are purely my own opinion and is intended for a general audience. Please perform your own due diligence and research for your specific financial circumstances before making an investment decision.



Via SeekingAlpha.com