Mastercard: The Valuation Limiter

by The Compound Investor

Mastercard (MA) stock has surpassed all expectations since I last covered it in April. Back then, shares of the payment processing giant changed hands for around $230 each. They closed out yesterday at just over the $340 per share mark. Call that a near 50% gain in a little under eight months – slightly more when inclusive of dividend cash. As you can imagine, those are not words I envisaged typing back in the dark days of the second quarter, but I guess you could say that about a lot of stocks.

At the risk of stating the obvious, there is an awful lot to like about this one. Operating what amounts to a levy on $6.5t worth of annual card payments is a lucrative money spinner. The firm’s profit metrics are freakishly high, and it enjoys a long runway in terms of growth prospects. Overall, that combination makes for a very impressive compounding machine. Net income per share has increased by a factor of around six over the past decade, with shareholder returns running even higher than that. If not for the ever-present threat of regulatory and legal trouble, and possibly technological disruption too, it would be tempting to view this as the perfect investment.

The COVID pandemic has also thrown a spanner in the works, but hopefully just a temporary one. The firm reported year-to-date adjusted net income of $4.8b at the end of 3Q20, an 18% currency-neutral drop on the $6b it made in the 2019 period. That may not look great, but profits should recover very quickly here. Indeed, analysts have FY21 net income at over $8 a share, which represents a full recovery to pre-COVID levels. The balance sheet also remains in excellent condition – net debt levels under $2b only represent a quarter of pre-COVID annual net profit.

The Valuation Limiter

Back in April, Mastercard stock traded for just under 29x FY19 net profit. I remarked that it represented a decent long-term deal, even though it may not have appeared so at first glance. Ultimately, it was not that much of a premium to burn off given underlying double-digit annual growth. That is before mentioning the impact of ultra-low interest rates on equity valuations too. That said, and given the significant share price appreciation here, it is probably worth a second look.

As mentioned above, the stock now trades some 50% higher than its level in early April. If we take analyst profit estimates at face value, then we are looking at around $10 per share by FY22. The current share price is just over $340 – with quick math therefore putting the valuation at around 33x forward earnings. As crazy as it might sound, I think the stock has every chance of eventually justifying that. It can do so in much the same mould as the best names from the Nifty Fifty did. Obviously this assumes no external hit to the profit engine, whether legal or otherwise, because other than that its growth prospects and earnings quality remain superb.

(Source: Mastercard 2019 Investment Community Meeting)

This does, of course, imply a long-term outlook too. And that tees up a potential banana skin in the medium term. Indeed, it is not hard to imagine some valuation multiple compression taking place here. That is simply the cost of seeing shareholder returns far outstrip underlying profit and dividend growth. Over a period of a couple of decades, it may not seriously dent the cumulative impact of strong profit growth and dividend reinvestment. For that reason, I still think Mastercard stock will do very well on that kind of timeframe. However, that valuation limiter is worth bearing in mind, especially in the near term.

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