I did a Square (SQ) analysis last week and focused on the change in valuation over the past several months. I explained why I think Square is the major player in the fintech world, and why I think its growth prospects are conservative so far. During the evaluation section of the article, I mentioned some of Square’s peers: Mastercard (MA), PayPal (PYPL), and Visa (V).
Visa was the cheapest of the four, and was also trading at a premium to the general market. In this article, I will delve deeper into Visa. I’ll try to determine how the valuation gap affects investment decisions, which investor should consider Visa, and which investor should consider Square.
I will analyze the company using the chart below, which is my methodology for analyzing earnings growth stocks. I am using the same methodology to make it easier to compare the analyzed stocks. I will research the company’s fundamentals, its evaluation, its growth opportunities, and its risks. I will then try to determine if it is a good investment.
(graph by author)
According to research on Alpha Overview, Visa operates as a worldwide payments technology company. The company facilitates digital payments between consumers, merchants, financial institutions, businesses, strategic partners, and government agencies. It operates VisaNet, a transaction processing network that enables the authorization, settlement and settlement of payment transactions.
Revenue has grown more than 10% annually in the past decade. You can see the revenue drop during the pandemic last year. Millions are locked in their homes, money saved due to uncertainty, and unable to buy due to the lockdowns. However, the company is expected to report an all-time high revenue this month when it summarizes 2021.
Visa revenue is growing due to organic sales growth, but also through acquisitions as the company acquired Visa Europe during that remarkable decade. Looking ahead, the consensus of analysts estimates, according to Alpha Quest, that Visa’s revenue will continue to grow by about 10% annually.
The EPS is growing at a much faster pace and is based on three main reasons: top streak growth, massive drop in shares outstanding, and better margins over the past decade as well. The company’s earnings per share has nearly quadrupled and is expected to return to an all-time high during October when they announce results for 2021. Looking ahead, the consensus of analysts, according to Quest Alpha, estimates that Visa’s EPS will continue to grow at around 20% annually. .
The dividend has been increasing annually since the company went public in 2008. Since then, investors have enjoyed 12 years of annual increases, and are expected to enjoy another dividend increase this month. Dividends are very safe with a low payout ratio of only 25%. I expect a modest increase that will push the compensation ratio down. The return on entry is not very attractive, but due to the growth rate of Visa, your return on cost will grow quickly, so you should still consider this if you are looking for long-term income.
Shares outstanding have also declined over the past decade. The number of shares has fallen by more than 20%, and the company is constantly buying more shares. In 2021, the company spent twice as much on buybacks than it did on dividends. I think buybacks at the current valuation are less effective than dividends, but I trust the current management team, as they have proven to specialize in efficient capital allocation.
The forward P/E ratio and the price to free cash flow ratio are two important metrics for understanding the current valuation. To the chart below I’ve added some of Visa’s payment industry peers. While Visa is not cheap with 31 times forward earnings, it is the cheapest in comparison to its peers. Whether we look at EPS or FCF, Visa is the cheapest and square is the most expensive of the four. The square is also growing at a much faster pace to justify an evaluation.
The chart below from Fastgraphs.com shows that Visa is cheap compared to its peers, yet quite expensive when compared to its historical valuation. The average P/E ratio for a company with a similar growth rate is 26, and the current P/E ratio, even when we ignore the pandemic, is much higher. Therefore, Visa is cheap compared to its counterparts, but not cheap in absolute terms.
Visa combines amazing basics with challenging valuation. Fundamentals show rapid top-line growth fueling net earnings growth which in turn fueling dividend growth and repurchases. However, the company at the moment is not cheap and the current rating is much higher than the average rating even if it is cheaper than its peers.
Visa is the largest payments network in the world. The company can transfer funds from anywhere in the world to anywhere. The company is adapting its massive network for additional use cases and additional payment methods. The company is working on adding bitcoin to the network which includes payments and rewards.
(Source: Visa Investors Day)
Additionally, it is working on more use cases for the Visa network and Visa branded cards. B2B payments as well as P2P payments that will allow businesses and individuals to take advantage of Visa’s worldwide money transfer network. Visa in the money transfer business, Visa Direct, sees a $65 trillion opportunity in money transfer, and plans to leverage its network to capitalize on it.
(Source: Visa Investors Day)
The margin of safety is perhaps the biggest risk in the short term for investors. Is paying 30 times the earnings of a company that is making 20% a year profit normal? I think so. However, if a company has a bumpy road along the way, fails to fully meet expectations, or simply faces more competition and regulation, that growth rate may slow. If that happens, investors have no margin of safety, as the company is priced for perfect execution.
Regulation and competition are the most important business risks for Visa. The network has a 50% share worldwide when we exclude China. This means that in the most profitable markets in Europe and North America, 1 in 2 transactions is made with Visa. This puts a huge target on Visa’s back. Regulators have constrained the company in the past and will likely try to constrain it further in the future, and the fintechs are seeing Visa’s success, FCF margins close to 50%, and they want a share of that too.
Visa is a safer investment compared to Square. The company is cheaper, has a stronger base and fundamentals, and has the ability to respond no matter what is happening in the market. With more than $12 billion in revenue, controlling the largest Visa payment network is a safer investment at the current valuation of both companies.
The box on the other hand is growing faster. While Visa has the largest network, Square is still building its own as it connects its digital wallet (Cash App) to its reseller platform. So, Square is growing faster as it builds and deploys its network, but the risk is also much higher. The stakes are higher with a valuation that requires a sustained rate of impressive growth.
So, if I have to recommend, it will depend on your goals. If you require income, Visa is your choice. Square has positive free cash flow, but it will take time before it starts paying dividends. If you are looking for total return, it depends on your investment horizon. If you’re investing for the long-term, Square’s volatility shouldn’t be much of a concern to you, and you’ll enjoy faster growth.
However, if you seek exposure to this industry but are willing to invest in the short or medium term, you will be much safer with Visa. The company has a small margin of safety, but it’s still a large margin of safety for Square. The shorter your investment horizon, the higher your interest in volatility and margin of safety. I own shares in both companies and believe that both Square and Visa will outperform the market in the long run.