A couple of weeks ago I posted a brief update on Mastercard stock. It always feels incomplete covering one of the payment processing giants without mentioning the other. That means a quick update is also due on Visa (V), which was last covered back in April. For the most part there is no discernible difference between these two. Visa is the larger, with TTM gross volume totaling $11.3t versus $6.3t for Mastercard, but let’s not split hairs. They clearly have similar (and fantastic) businesses, and shareholder returns to date have been exceptional.
Let us start on that point. What is it about Visa that has made it such an exceptional investment? Well, it is a combination of three points in my view. Firstly, the underlying business generates very high returns on capital. That is significant because it implies that Visa does not need to retain much profit in order to grow. It is also shielded from competition, which ordinarily would act to lower those returns. I mean, imagine trying to set up a network like Visa’s. It would be nigh on impossible. This makes it more valuable than the average company, all other things equal.
Now, that ‘all other things equal’ qualifier is important and brings us to the second point. What has made Visa so special is that its growth prospects have far exceeded that of the average firm. Historically, that average falls around the rate of GDP growth, which makes perfect sense. Visa has annihilated that number as folks continue to shift to digital payments over cash and checks. COVID has obviously held things up a bit, with FY20 non-GAAP EPS of $5.04 representing a 6.5% drop year-on-year. Even so, growth is expected to return in abundance from next year. FY23 EPS estimates of $8 per share imply 12% annual growth over a trailing 5-year spell.
That brings us to the final point: the valuation. Now, the net effect of points one and two above is that Visa should command a meaty premium to the broader market. And right now, it does. The stock price stands at circa $208 per share, with estimated FY21 profit running at $5.45 per share. Quick math puts the valuation at around 38x annual profit. The S&P 500, on the other hand, has a current value of around 3,675 – with FY21 profit estimates running at circa 170. Call that a multiple of around 22x earnings. So, Visa currently commands a roughly 70% premium to the wider market.
Interestingly, there were times when the stock did not come anywhere near to sporting a premium. Check out the situation back in early FY11 for example. Visa stock traded as low as $16.50 per share, or around 12.7x split-adjusted earnings of $1.30 per share. The wider S&P 500 also traded at circa 12.5x earnings. Why should a firm that can grow profit well in excess of GDP growth while throwing cash at dividends and stock buybacks not command a higher valuation? Of course it should.
When you combine all of the points above, you get the trifecta. That is to say, strong profit growth plus dividends & buybacks plus an expanding valuation. No wonder folks have made so much money here in recent years. And yes, the same is true of Mastercard stock also.
The Valuation Limiter
Global GDP has expanded at a rate of around 5.5% per annum on average over the past four decades. At some point in the future, that is therefore what you might expect Visa’s revenue to grow at. At that point, it seems fair to me that the stock could command a valuation in excess of 25x annual profit. I base that on a 4% yield of dividends and stock buybacks, plus that 5.5% annual growth figure, leading to returns in the 10% per annum area. I say ‘could’ because I am obviously making assumptions about litigation and regulation (and technology) not seriously impacting its underlying business.
As per above, Visa stock trades at around 38x earnings right now. That future contraction sets up the ‘valuation limiter’, which I mentioned in the previous piece on Mastercard. This, of course, knocks out the third point from our trifecta above. That said, and because Visa still has many years of above average growth ahead of it, not to mention still deserving a relatively high terminal valuation, I do not expect this to seriously impact shareholder returns on a long-term horizon. The current valuation therefore seems justified.
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