PayPal takes a small portion of the payment amount as a fee for this service. This transaction fee is about 2% of the purchase volume and is thus already neat. The more purchases that are paid for with PayPal, the higher the revenues and profits - it is therefore a highly scalable business model. In addition to this payment processing, PayPal also offers free money transfer between individuals.
Why did the stock crash?
There is no one reason why the stock sold off. Rather, it is numerous problems at PayPal that can be blamed for the crash.
Disappointing quarterly figures
At first glance, the numbers weren't that bad. In terms of revenue, analyst expectations were exceeded. In the 4th quarter PayPal achieved a turnover of 6.92 billion USD, the analysts had expected only 6.89 billion USD. However, the adjusted operating margin was disappointing. While analysts had expected an average of 23%, PayPal only achieved 21.8%. As a result, earnings per share were $1.11, compared to $1.12 expected. So what? This cannot explain such a plunge in the share price.
Worse than the slight miss in earnings per share was the outlook. After all, the stock market always trades the future. PayPal expects 15 to 20 million new customers in fiscal 2022. That is significantly less than the analysts believed. These assumed an average of 55 to 60 million new customers. Fewer customers also means less growth. As a result, analysts are having to adjust their earnings estimates downward, and the valuation of the stock is falling.
Added to this is the fact that around 4.5 million illegally created accounts were also discovered, which are now being deleted, thus also lowering the total number of users in the statistics.
High fees, falling margins and the fear of competition
PayPal is both a blessing and a curse for merchants. Users love PayPal because of its ease of use. This allows merchants who offer PayPal as a payment option to sell their products better than competitors who don't. However, PayPal makes itself pay dearly for this advantage. Merchants complain about high costs. There are certainly many who would rather use a less expensive alternative to PayPal.
The competition is large and has grown strongly in recent years: Visa, Mastercard, Block, Apple Pay, Google Pay, Amazon Pay, etc. It is therefore questionable whether PayPal can maintain the high fees and associated margins.
eBay switches to its own payment system
Thanks to eBay, PayPal is where they are today. But what once belonged together is now going separate ways. Already years ago, it was started to end the cooperation step by step. In 2015, PayPal was separately listed on the stock exchange. In 2018, eBay announced that it wanted to phase out the partnership.
Since eBay now uses its own payment system for transactions, PayPal is losing quite a chunk of revenue. CEO Dan Schulman indicated in a conference call with analysts that this will cost about $600 million in revenue in the first half of the current year.
Valuation
When companies fail to meet expectations and are also highly valued, it comes as it must: The stock collapses. And that's exactly what we saw with PayPal. In the course of the pandemic, the share price was driven to unimagined heights. On the following chart you can clearly see that until the outbreak of the Corona pandemic the share price ran upwards in line with the profit development. Then, from 2020 onwards, there was a veritable share price explosion and the share price rose much faster than earnings. The result: a very high overvaluation, which has now been reduced again.
But you can also see on the chart that the share price has now fallen more than earnings. If the current earnings expectations come true, the share could now be worth buying again at a discount (more on this later).
Growth
Sales and profit development could hardly look better, could it? Both are running from bottom left to top right. At present, analysts continue to expect growth rates of between 17 and 19% over the next three years.
Risk and profitability
PayPal has no net debt, but even USD 9 billion liquidity. Thus, there are no major risks on the balance sheet. In fact, PayPal is even in a position to put out feelers for one or the other takeover candidate if necessary. In addition, PayPal does not have to fear rising interest costs due to the planned interest rate increases.
It is also nice that PayPal has managed to increase profits every year. With a return on equity of 22% and an operating profit margin of 23%, PayPal is also well positioned in terms of profitability.
Valuation
As part of the valuation, I always look at various indicators. Only the simple DCF model is included in the scorecard. With this, I look at whether PayPal could be a good investment in the long run. Nevertheless, one should also consider other methods for an overall picture.
Simple DCF Model
As with any stock analysis, I use a simple discounted cash flow model to value PayPal stock. This model is based on the assumption that the enterprise value must equal the sum of all future profits. Since one Euro of profit in the future is worth less than one Euro today due to inflation or opportunity costs, the estimated future profits are discounted to today's reporting date.
The starting point is the net profit expected by analysts for 2024. The crucial question now is how growth will continue thereafter. In the next three years, operating profit is expected to grow by around 17.5% p.a.. For this stock analysis, I prefer to take a conservative estimate and assume further growth of 14% p.a.. As always, I have also assumed that growth will reduce by 25% every 5 years.
These assumptions result in an expected annual return of 10%, which implies a valuation score of 82% (100% is achieved at 12.5% expected return).
Fair Value Valuation
I had already shown that the share price had run ahead of the earnings trend. Assuming that the price and earnings perform evenly over the long term and assuming a fair P/E ratio of 30, the fair value of PayPal stock in 2 years is $175. This would be an annual return of 30% that could be achieved with the PayPal share.
Should you buy or sell PayPal now?
We've seen why PayPal stock has fallen so much. Is it now a favorable buying opportunity or should we expect PayPal to underperform in the long run?
PayPal is undervalued
I think PayPal is currently worth buying and that the stock has been punished too much. The valuation currently appears to be very attractive. The stock love score is over 80%. All valuation techniques point to PayPal stock being undervalued. The free cash flow yield is more than 5%! This is a value that is usually only found in value stocks. If the entire free cash flow were distributed to shareholders as a dividend, this would correspond to a dividend yield of more than 5%.
Furthermore, despite slowing user growth and increasing competition, I remain convinced of the business model.
Scalable business model with high network effect
Even if PayPal's growth in users is not quite as strong as it has been in the past, every additional customer means increasing profits. The business model is highly scalable. The infrastructure and technology are in place. If new buyers are added, PayPal does not incur any additional costs; pure profit is generated.
It also benefits from very strong network effects. PayPal is world-famous and very widespread. I myself like to use PayPal because of its simple and intuitive handling. There is a buyer protection, which secures me in anonymous transactions on the Internet. In addition, the app is really easy to use.
From my own experience, I know that I prefer to shop online where PayPal is also offered to me as a payment option. So the more users PayPal has, the more merchants are forced to offer PayPal as a payment option. By being able to send money to each other for free, the user base will grow steadily. And once you are a PayPal customer, there is nothing to stop you from using it to pay for your next purchase.
Large customer base enables expansion of the product range
PayPal has long since begun to offer other products in addition to payment processing. A big trend, and therefore a big opportunity, is the introduction of the "buy now, pay later" feature. Customers can use it to buy products on credit without the need for a credit card. PayPal pays the merchant (so the merchant gets the money right away) and then the buyer pays the purchase price back to PayPal later. PayPal then earns money from the "credits" issued in this way.
Furthermore, it is also possible to trade cryptocurrencies via PayPal in the USA and Great Britain. With this, PayPal could generate many more sales overnight, since a part of the already existing users surely also buys via the PayPal app. This possibility could still be rolled out for other countries.
I still think PayPal stock is worth buying. Due to the correction, the stock is attractively valued again. In fact, I think that the price has gone down far too much and now again a very good risk-reward ratio is offered in the stock. PayPal certainly has to face increasing competition. However, due to its great market positioning, I am optimistic that PayPal will succeed.
