PayPal: A Dream Entry Point In A Long Term Compounder (NASDAQ:PYPL)
The recent selloff in high growth, expensive tech companies has claimed too many victims to count. Many companies with high revenue growth rates have drawn down anywhere from 50-75% from their all-time highs in 2021, and QQQ, the Nasdaq 100 ETF, is hovering on the edge of a bear market.
It appears as though the market may have gotten ahead of itself.
Thankfully, for us, sentiment has now swung to an extreme in the opposite direction, and investors in the high growth tech sector seem to have thrown the baby out with the bathwater. This selling frenzy over the last few months has presented us with an excellent opportunity in PayPal stock (PYPL), which has all the hallmarks of being an excellent long-term wealth compounder. Purchasing shares at its current deflated valuation seems like an extremely attractive entry point to begin building a position.
What is a “Compounder”?
Before diving into the specifics about what makes PayPal such an attractive long-term investment, it’s important to define exactly what we mean when we’re talking about “compounders”. Compounders are companies that offer the unique prospect of compounding an investment’s value at a higher-than-average rate, and different analysts have different ways of defining these types of opportunities. Some look at return on invested capital, some look at qualitative things like management/moat, and some measure IRR. We take a different view.
Compounding doesn’t happen automatically – it requires buyers and sellers in the market to agree that an asset’s value has increased vs. the year before. Thus, when it comes to finding an asset that will compound its value over time, there are only two factors that matter: supply and demand.
Let’s take a look at a quick example, using two stocks with drastically different supply and demand profiles.
This first company is Moody’s (MCO). As you can see, Moody’s has been growing revenue and earnings like clockwork over the last decade. This increased utility has led to an increase in demand for shares in the growing enterprise. In this way, we can use increasing revenue (scale of the business) and increasing earnings (competitive advantage, profit for investors) as proxies for demand.
But what about supply? Well, as it turns out, Moody’s has also been retiring shares from the outstanding investor base, buying them up in the open market. Long-term investors have seen their percentage ownership of the business increase over the last 10 years, without doing anything. As a result, even if the business hadn’t grown at all over the last decade, earnings per share would still be increasing.
When you put these two dynamics together, it can be an incredibly powerful compounding force. Check out how the company’s stock has performed since 2010: it’s up over 1,000%.
On the flip side, let’s take a look at a company that has much worse supply and demand dynamics. Let’s look at AT&T (T).
First: the good. Revenue has increased from $120 billion to $168 billion over the last decade, growth of more than 40%. However, earnings have stayed mostly flat, meaning that margins have deteriorated significantly. The company also pays an ~8.5% dividend. This is a mixed demand profile for the stock.
What about supply? Supply in shares of AT&T has grown. The company has used its equity as a weapon, and diluted shareholders to raise capital/make acquisitions. This can make sense if the move is accretive, but, clearly, it hasn’t been, as it hasn’t shown up in more than a decade of earnings.
Thus, it should be almost no surprise that AT&T’s shares have languished, actually down more than 14% over the last 12 years.
Remember: actions speak louder than words. No matter what investors, analysts, or executives say, if the supply and demand dynamics aren’t in your favor, then capital appreciation can be an uphill battle.
What makes PayPal a compounder?
In short, PayPal is a compounder because it has the same favorable supply and demand dynamics that all great compounders share.
First, let’s take a look at PayPal’s revenue.
PayPal’s revenue has exploded over the last 5 years, growing from $11 billion TTM to $25 billion TTM. This is incredibly impressive and represents nearly an 18% CAGR. Clearly, the size of the business is increasing as executives have executed their business plans competently.
The same trends exist when it comes to net income.
While the standard deviation in the trend of net income is higher than the rhythmic pace of increasing revenue, the growth has been quicker. Since 2017, net income has grown from $1.51 billion TTM to $4.17 billion TTM, representing a CAGR of 22.52%, even higher than the revenue growth rate.
In short, the increasing utility of holding PayPal stock creates highly favorable long-term demand trends.
What about supply of PayPal shares?
Shockingly, supply in shares has actually decreased over the last 5 years, as PayPal has retired shares from the open market. While the decrease in share count has not been drastic – decreasing from (diluted) 1.22 billion shares to 1.18 billion outstanding shares – PayPal management has shown that they aren’t willing diluters of the company’s stock.
So, to recap, supply and demand trends in PayPal stock make it a highly attractive potential long-term investment.
Why is now a good time to buy?
Right now is a good time to buy because the stock is incredibly discounted and technically oversold.
From a technical perspective, the stock is the most oversold it’s ever been on the weekly chart, with a current RSI reading of 17.2.
When stocks get this “extreme” on one side of the market or the other, it usually means there’s an opportunity for a sharp trader or investor out there. For us, this oversold condition isn’t likely to hold forever, and thus it presents an opportunity, especially given the positive, longer term supply and demand dynamics already discussed.
Additionally, from a valuation standpoint, the stock is the cheapest it has ever been in terms of net income multiple. Right now, you can purchase shares in PayPal at only 27 times earnings, a significant historical discount. You can see below that shares have dipped into extreme value territory, trading out of the gently upward sloping standard deviation valuation on both earnings multiple and sales multiple:
While it’s possible that these extreme technical and valuation readings are a result of “the market trying to tell us something” about PayPal, it’s far more likely that this is a “buy when there is blood in the streets” opportunity. Fading fear in proven winners has proven to be a historically profitable strategy.
So, what are people worried about, anyway?
There are a number of factors having to do with this recent decline, chief among them the cyclical low we seem to be experiencing in the rate cycle. As rates go up, the net present value of future cash flows goes down, the common thinking goes. As growth gets more and more discounted, companies that derive a significant portion of their value from the future become less valuable. This is especially true for companies with no earnings to speak of. As a result, nearly all of the high growth companies on the market today (which obviously derive a lot of their value from the future) have been sold indiscriminately.
However, PayPal is a profitable, growing company, now. It’s different than the rest. It has a profitable business plan it’s executing. It’s produced billions in earnings for its investors, and meaningful revenue growth as well.
Some have mentioned that the re-rating the stock has experienced is a result of a pull-forward in demand for its services. While this seems true based on the data, a local top in net income growth isn’t likely to mean an all-time high, especially for a company in a market as big as PayPal’s. Fears about this have led to selling, which has led to more fear, which has led to the price controlling the narrative. Understanding the bigger picture and making a contrarian bet now, with the long-term probabilities at our back, seems to be the smartest course of action.
Risks & Summary
While it seems as though the risks are priced in at this point, there is further risk that management stops executing, and the demand for PayPal shares is dampened dramatically over time. There is also the risk that the selling momentum is not over yet.
Despite this, on balance, this selloff may prove to be an excellent opportunity to snag yourself a piece of this long-term wealth compounder. PayPal has shown that it is a strong performer. Don’t let short-term bumps and emotional price action cloud the bigger picture.