PayPal Holdings - An Important Lesson In Overvaluation

For the word of the Lord is right, and all His work is done in truth. He loves righteousness and justice; The earth is full of the goodness of the Lord.

Psalm 33:4-5

For some, it may seem difficult to accept God’s word as truth, especially as one can simply say that the Bible is a book just like any other. What I have found is that there are many ways to use archaeology, science, and history to prove Biblical truths. As I’ve sought the truth more and more ironically it has become increasingly harder to disprove what the Bible says. I unequivocally believe that Jesus Christ is my Lord and Savior, and that His word is good and perfect. God loves everyone and has created all of us in His image, His only desire for us is to accept Him.

Truth is very hard to identify when it comes to the stock market. What is truth when a company reports its results, it’s highly subjective professionally and for retail investors. On the one hand the company may have missed, met, or exceeded certain expectations and the market reacts, but there still may be other elements contrary to the market’s move. This subjectivity places the burden of truth on investors’ goals, objectives, and associated management strategies. Without these defined principles, there is no end to spin-cycle thought processes and inevitable paralysis.

It's been interesting to dissect Big-Tech through the Big-Tech Investment Series. Valuation has been a core theme for this series and PayPal Holdings, Inc. (PYPL) is a must-have overvaluation discussion topic.

Many are familiar with PYPL’s story, especially with ties to Elon Musk, Peter Thiel, and Max Levchin. Since PYPL’s spin-off from eBay, Inc. (EBAY), PYPL witnessed an annualized revenue growth rate of 18 percent from 2013 through 2021. Since then, this annualized rate has dropped to 7.9 percent in the past three years. From 2016 through 2024 PYPL’s operating cash flow increased at an annual growth rate of 11 percent.

Since 2016, PYPL has witnessed an annualized stock price return of just over 10 percent. So why did PYPL’s valuation level become so excessive, and how should investors think about the company’s future and avoid another overvaluation situation.

During President Trump’s first administration, PYPL like many other stocks witnessed an expansion for its multiples including enterprise value to sales and operating cash flow per share. This increased premium was exponentially inflated during the pandemic which was a common theme across broader markets.

For payment-based companies there is one metric that is more critical than others, the take rate.

The take rate is simply net revenue divided by gross payment volume. Like any network or large-scale system, the take rate is a measure of strength with opposing forces. On one hand, payment volume is a demand driver across the network, on the other hand, the take rate is the cost for the transaction through the network. In PYPL’s case, the take rate has become the weaker link, as payment volume increases, PYPL’s take rate continues to decline illustrating PYPL’s willingness to make its cost cheaper to encourage volume growth.

Major players like Mastercard Incorporated (MA) generate an inverse relationship with the take rate increasing as a portion of gross payment volume. This signifies a company like MA having pricing power in addition to volume power across its network. This is a direct reason why MA and Visa, Inc. (V) trade with an operating cash flow per share multiple around 30 times or more than double that of PYPL’s multiple being in the low teens.

Another illustration of PYPL’s take rate impact is a declining operating cash flow margin. In 2013, PYPL’s cash flow margin was at 30 percent whereas the 2024 margin stands at 23 percent. Compare this with MA’s 2010 cash flow margin being 31 percent and now standing at 52 percent. As PYPL’s recent payment volume growth has slowed, the company finds its current valuation multiple near an all-time publicly traded low.

PYPL’s prospects still may see the company generate 10 percent in net revenue growth over the mid-term. However, this rate of growth is not going to justify PYPL a cash flow multiple any higher than around 15 times as a best-case scenario. Digging deeper into PYPL’s opportunities may afford retail investors a good risk/reward position today if PYPL can re-accelerate growth. But retail investors need to continue to strictly monitor PYPL’s take rate, especially during times of increasing volatility as has occurred the past four years to gauge levels of overvaluation. PYPL will trade a substantial discount to peers like MA and V as long as it continues to see its take rate decline.

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