From a pure business dominance perspective, I can think of few businesses in the history of Western Civilization that have created a better combination of ubiquity and high growth than the e-payment network giant Visa (V). Companies that receive payments, which are loathe to pay out fees for each transaction, have little choice but to gin up and bear it because customers avail themselves of making purchases with either Visa, Mastercard, American Express, Discover, a debit card, a store card/private label card, or cash.
Outside of tech, the net profit margins of 43.8% are so fantastic among blue-chips as to be essentially peerless. I remember watching old Warren Buffett lectures from the early 1990s when he would brag about Coca-Cola’s profit margins in the 26-28% range and cite that fact as a heavy indicator that an investor has found a fantastic long-term investment. It appears you’ve found the top of the investment mountain when you have located a business that is 1.5x as profitable as the exemplar business that Warren Buffett has long held up to the investment world.
The profit margins at Visa, and the relatively fixed costs inherent in building a payment network, have supported extreme profit growth over the recent medium term, as earnings per share have grown at a rate of 21% over the past five years.
It seems to be self evidence that Visa currently enjoys about as strong of competitive economics as any company that you will ever come across. The more discerning part is figuring out how the current valuation, at a price of $147 per share as of Friday’s close, will bear on the future returns, as the current P/E ratio is 32-33, based on 2018’s expected earnings.
My view is that Visa, which currently enjoys a $330 billion market capitalization, will grow earnings at a rate of 12% to 15%, in addition to its 0.5% present dividend yield, and have a long-term P/E ratio of 20.
Based on those assumptions, and Visa’s current earnings per share base of $4.40 per share, I expect that Visa’s earnings per share will be somewhere between $14.52 and $19.54 per share, depending upon which side of the 12% to 15% expected growth spectrum proves to be a more accurate estimation.
At a P/E ratio of 20, we would be looking at a stock price of somewhere between $290 per share and $390 per share a decade from now. If there is 12% annual earnings per share growth, I would expect that the stock price would then increase at a 7% annualized rate. If there is 15% annual earnings per share growth, I would expect that the stock price would then increase at a 10.2% rate.
Figuring in the modest dividend, Visa shares are likely to deliver 7.5% to 10.7% annual returns from this point forward. To do better than that, you would need to rely upon a combination of greater than 15% annual earnings per share growth or a long-term P/E ratio of greater than 20x earnings, which I regard as too speculative and uncertain to actually rely upon for a company of Visa’s size.
Of course, the real risk is that the company does good, but not excellent. It is not inconceivable to imagine a world in which Visa only grows earnings at 8% for a decade–still a commendable feat!–and has a P/E ratio of 18x earnings a decade from now. In that scenario, earnings per share of $9.77 would translate into a stock price of $175, for a stock price of $175 per share in 2028. That would be a 1.76% compounding rate, which inclusive of dividends, might be more like 2.3%. That is the hard part of projecting valuations. If the growth is lower than anticipated, you get the double whammy of a lower P/E ratio multiplier for the value of the stock, so your returns get cut down to size on both ends. As a result, it is on the table that Visa could have a high single digit compounding rate and compound at a rate lower than inflation for the next decade.
If I were managing an institutional account, I would firmly regard Visa as a hold at this time. It has dominant competitive advantages, and has almost a half century history of growing at a double-digit rate, and I would not want to release an ownership position in that kind of asset. That said, I would not buy here. To get 10% returns from the stock, you will need somewhere in the range of 15% annual earnings per share growth, which is possible, but I do not like situations where dominance is required to obtain a double-digit compounding return. If I wanted to own Visa due to knowledge of its dominant business position, but need to talk myself into self-restraint due to the valuation, I would remind myself that the current valuation of 32x earnings is the highest since Visa’s IPO in March 2008 and that the stock traded below a valuation of 21x earnings for a greater portion of its trading history than the amount of time it has traded above that valuation. For the patient, the time to make the easy decision to buy this stock will someday come.