Babylon Capital® Quality & Valuation Analysis On PayPal | The Potential For A Significant Rebound Once The Narrative Flips

After reaching a peak of $310.16 on July 26, 2021, PayPal’s PYPL stock has declined by about 80%. While much of this sell off is justified (considering that PYPL traded for more than 50x earnings for most of 2021), I believe this sell-off is overdone and that PYPL offers investors with a favorable risk-reward opportunity. 

• NTM Price to Earnings Ratio: 11.93x
• Historical Mean: 32.14x
• NTM Free Cash Flow Yield: 9.44%
• Historical Mean: 4.36%

Today, investors are expected to receive significantly higher earnings and free cash flow per share. Given its fundamentals, PYPL appears to be undervalued.

Before analyzing PYPL’s valuation, let’s explore why PYPL is a quality business with the capacity to endure a challenging period.

BALANCE SHEET:

• Cash & Short-Term Investments: $9.90B
• Long-Term Debt: $10.55B

PYPL maintains a strong balance sheet, evident in its A- S&P Credit Rating.

RETURN ON CAPITAL

• 2017: 12.9%
• 2018: 12.7%
• 2019: 12.4%
• 2020: 11.5%
• 2021: 13.6%
• 2022: 12.7%
• LTM: 14.3%

RETURN ON EQUITY

• 2017: 11.7%
• 2018: 13.1%
• 2019: 15.2%
• 2020: 22.7%
• 2021: 20.0%
• 2022: 11.5%
• LTM: 20.7%

PYPL’s return metrics are healthy.

REVENUES

• 2016: $10.84B

• 2017: $13.09B
• 2018: $15.45B
• 2019: $17.77B
• 2020: $21.45B
• 2021: $25.37B
• 2022: $27.51B
• 2023: $29.66B* (Full-Year Estimate)
• CAGR: 15.46%*

FREE CASH FLOW

• 2016: $2.49B
• 2017: $1.86B
• 2018: $4.65B
• 2019: $3.67B
• 2020: $5.35B
• 2021: $4.89B
• 2022: $5.10B
• 2023: $4.95B*
• CAGR: 10.31%*

NET INCOME (EARNINGS)

• 2016: $1.40B
• 2017: $1.79B
• 2018: $2.05B
• 2019: $2.46B
• 2020: $4.20B
• 2021: $4.17B
• 2022: $2.42B
• 2023: $5.52B*
• CAGR: 21.65%*

Based on Full-Year 2023 estimates, PYPL has demonstrated decent growth in its Revenues, Free Cash Flow, and Net Income over the past 7 years.

SHARE BUYBACKS

• 2017 Shares Outstanding: 1.22B
• LTM Shares Outstanding: 1.14B

By decreasing the number of its shares outstanding by about 6.5% since 2017, PYPL managed to boost its earnings per share by 7% (assuming no growth).

As you can see, PYPL is a business that has the quality characteristics to weather the recent challenges.

Now let’s shift our focus to valuation.

If you look at PYPL’s stock chart without knowing anything about the company’s financials, you might think that PYPL is going out of business. However, the financial data above shows a business that has been consistently growing its revenues and profits while maintaining a stable level of free cash flow over the past few years, all while maintaining a strong balance sheet.

Let’s highlight this point further by including some highlights from PYPL’s Q2 Earnings Report:

• Q2 2023 Total Payment Volume: $376.54B (+11% YoY)
• Q2 2023 Payment Transactions Per Active Account: 54.7M (+12% YoY)
• Q2 2023 Number of Payment Transactions: 6.07B (+10% YoY)
• Q2 2023 Active Accounts: 431M (flat YoY)

Once more, you can observe that PYPL's business seems to be holding up well.

So what’s going on? Just two years ago, the narrative surrounding PYPL was all about its "Tremendous Growth Potential" as a fintech giant. But today, the narrative has shifted to one of "Growth Problems" and even disaster. Has the actual business undergone such a significant transformation? I don’t think so. Rather, it seems that the market sentiment, often referred to as "Mr. Market," has influenced and amplified the negative narrative, leading to a state of peak pessimism around PYPL's stock.

Look at what happens when we flip the script:

Just two years ago, PYPL was trading at a Price to Earnings Ratio of 54.00x, largely due to a cheery consensus. To justify that valuation (using Benjamin Graham’s 2G rule of thumb), PYPL would have needed to achieve a 27% CAGR in earnings for several years ahead. Doesn’t that seem a bit excessive? Wouldn't it have been more appropriate for the headlines to reflect that PYPL has “Growth Problems," given the likelihood that PYPL might struggle to meet such aggressive growth expectations?

Today PYPL trades at 11.93x NTM earnings. Shouldn’t the headlines today read “A Fintech Giant With Tremendous Growth Potential” due to the fact that the compressed multiple and reasonable growth expectations seem to suggest a more positive outlook for shareholders?

Looking ahead to the Full-Year 2023, PYPL has provided guidance for $4.95 in Adjusted Earnings per share. If we assume that PYPL can achieve a 9% annual growth rate for Earnings over the next 5 years, this outlines the potential trajectory for PYPL’s Adjusted Earnings per share:

• 2023: $4.95
• 2024: $5.39
• 2025: $5.88
• 2026: $6.41
• 2027: $6.98
• 2028: $7.61

Assuming PYPL can be valued at 18x Earnings (a reasonable assumption under the 2G guideline), its potential value around 5 years from now could be about $137 per share. This projection suggests a CAGR of over 15% based on its current price of ~$62.75. This doesn't appear to be unreasonable.

It's worth noting that PYPL faces significant competitive risks. The fintech industry is crowded, and PYPL might be losing market share in its branded checkout. Additionally, there's a chance that PYPL might not meet expectations due to various factors, including macroeconomic challenges and margin pressures.

However, considering it has over 400 million active accounts and more than $1 trillion in annual TPV (Total Payment Volume), I am cautiously optimistic that PYPL can reverse this narrative. Moreover, the current valuation appears to provide investors with a margin of safety, making PYPL an appealing 'turnaround' opportunity with a favorable risk-reward profile.

*The valuation data utilized in this article is subject to potential changes and may not reflect current market conditions or future developments beyond the time of submission for publication.

Disclosure: I do not have a position in PYPL. Babylon Capital® and / or its client(s) have positions in the securities discussed in this article. The information contained in this article is intended for informational purposes only and should not be construed as investment advice to meet the specific needs of any individual or situation. Past performance is no guarantee of future results. Information contained in this article has been obtained from sources believed to be reliable but is not guaranteed as to completeness or accuracy.