Absent a recession, it is almost always a given that a company growing at a fast rate will trade at a premium P/E valuation compared to the S&P 500 as a whole. One of the trickier aspects of investing is trying to figure out when you should pony up and pay the premium anyway (see Nike these past seventeen years) or recognize that the valuation has become so high that it will lead to subpar returns (see Coca-Cola these past seventeen years).
Mastercard is a company that has frequently caught my eye not just for its fast growth, but for the amount of money that can be extracted without threatening the competitive position of the business. The business is truly exceptional–it generates $9.7 billion in revenues and $3.7 billion ends up flowing to the bottom-line as profit. That is a profit-to-revenue ratio of 38%. One of the best businesses in the world at generating extractable cash, Coca-Cola, creates $8.8 billion in profits against $45 billion in annual sales for a profit-to-revenue ratio of 19.55%.
The advantage of the credit card industry is that the amount of cash thrown off from the core businesses greatly exceed the reinvestment requirements to build out the networks and issue money to borrowers. It is a shareholder dream, because you see rapidly increasing earnings, dividend hikes, share buybacks–it is a non-stop process of figuring out ways to make shareholders richer.
Since 2005 (the first year Mastercard began reporting profits for public consumption although the IPO didn’t come until May the following year), Mastercard has grown earnings per share from $0.20 to $3.30 at the end of 2015. This has made Mastercard one of the absolute best investments you could have made this past decade, as the stock compounded at 38.2% annualized. A $50,000 investment into the IPO would have grown into $1.1 million today.
But you should recognize that about a third of those gains have come from an extending P/E ratio. In 2006, Mastercard earned $0.2 against a $4 stock price for a P/E ratio of 20. Now, the stock price of $98.59 is almost 30x the expected 2015 earnings of $3.30. If the stock maintained the same valuation throughout the past nine years, then the stock would be trading at $66 per share. Going back to our $50,000 into $1.1 million investment, we should recognize that 33% of the gains are due to an expanding P/E ratio. The fundamentals of business growth have taken the $50,000 investment to $737,000 and the investment community choosing to value the stock at a higher rate has taken the investment gains from $737,000 to $1.1 million.
This is relevant because it informs how we recognize the role of valuation in projecting the total returns offered by Mastercard shares. The 2006-2015 investors benefitted from 33% growth of the valuation in addition to growth in earnings; what can the 2016 to 2025 investors in Mastercard expect?
My opinion is that Mastercard deserved to be valued richer than the rate experienced during its early trading days–the 20x earnings rate in 2005 and 2006, the 18x earnings rate in 2007, the 16x earnings rate in 2009-2011, and the 20x earnings rate in 2011 and 2012. Each of those periods had some unique element weighing on the stock: the novelty of the firm’s existence as a publicly traded enterprise, the recessionary pricing that took all stocks down during the financial crisis, and then concerns about regulation of rates that credit card firms could charge merchants and the banks with whom they have relationships.
My valuation of Mastercard is the following: it should be valued at the low end of 20x earnings when there is regulation pending or some firm-specific item weighing against the stock such as high default rates, and it should be valued around 25x earnings in the absence of industry-altering regulations or poor economic conditions. With Mastercard earning $3.30, that would suggest a fair value somewhere between $66 and $82.50. The current price in the $98 range would suggest a premium of 15% compared to the highest valuation to justify and a 32% premium compared to the low end of fair value.
A question I seek to answer is this: What are the medium-term consequences of paying a 15% to 32% premium for an exceptional, fast-growing company?
The consensus earnings estimates for Mastercard in 2021 are $5.75. If that happens, based on my valuation estimates, Mastercard should trade between $115 and $143 per share. If the low end of fair value estimates prove true, then Mastercard investors should expect compounding of 3.25% annualized. If the high end of fair value estimates prove accurate, then Mastercard investors should expect annual returns of 7.85% for the next five years.
The current dividend is 0.77%, so that should augment returns on the low end to 4.02% annualized and raise the high fair value estimates to 8.62% annualized. This puts Mastercard squarely between the Nike and Coca-Cola valuations that existed in 1998. The earnings growth of Mastercard is not so substantial that it can beat the market even with some eventual P/E compression. Yet, the valuation is not so extreme that it guarantees mediocre returns like you saw from Coca-Cola in 1998.
To me, this is the classic definition of what a hold stock looks like. Unless you are certain of 16% or higher annual earnings per share growth, you don’t want to pay 30x normalized earnings for any business. On the other hand, if you already own a stock, it is difficult to find many firms in the country that are growing at a faster rate and there are almost no other businesses on the planet that generate such a high percentage of profits compared to revenues. Also, the dividend payout ratio is only 20%, and some significant growth may be in the offing as the dividend payments could grow in tandem with earnings growth and also inch forward towards the 40% range.
I am open to the argument that the truly exceptional businesses warrant paying a price that is a bit higher than you are customarily paying. For me, that means there should maybe be one or two dozen large-cap businesses in the world where you entertain the prospect of paying 25x earnings (rather than setting the cap at 20x earnings). With exceptional large-caps, the 30x earnings rate should be the firm hold territory–don’t buy at this price, but don’t sell if you already own it. And as you cross 35x earnings for a large-cap, you should probably sell even the superior business as the eventual P/E compression will be so extreme that it will eat up much of the future growth (and put you in a Silence of the Lambs horror-type scenario if the growth rate falls to the mid-single digit range).