Is PayPal Holdings Inc. Overvalued?

By Stocks Fool.com

Shares of PayPal recently slipped after Stifel Nicolaus and Piper Jaffray both downgraded the payment company's stock. Stifel's Scott Devitt downgraded the stock from "buy" to "hold" due to concerns about the company's valuation, growth prospects, and strategic execution.

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Piper's Gene Munster, who rates the stock "underweight", declared that the stock was overvalued relative to its long-term headwinds, and hada low probability of being acquired. Munster also warned that Apple's expansion of Apple Pay to in-browser and P2P mobile payments would hurt PayPal's sales growth. Let's take a look at PayPal's previous growth, upcoming headwinds, and valuations to see if these analysts are right.

Image source: PayPal.

How fast is PayPal growing?
PayPal's non-GAAP revenue rose 17% annually last quarter to $2.56 billion, beating the consensus estimate by $50 million. PayPal's total payment volume (TPV) rose 29% on a constant currency basis to $82 billion, compared to 27% growth in theprevious quarter. Merchant services TPV, which don't come from former parent eBay, rose 36% and accounted for 81% of PayPal's total TPV. Non-GAAP net income rose 27% to $443 million, or $0.36 per share, beating estimates by a penny.

PayPal's closely watched mobile payment volume rose 45% to $20 billion, accounting for a fourth of its TPV. Payment volume on Venmo, its social payments app, rose 174% annually to $2.5 billion, or 3% of its TPV. PayPal's acquisition of mobile remittances company Xoom, which closed last quarter, added 1.6 million active customer accounts to PayPal's user base and a single point to its overall revenue growth.

With those accounts included, PayPal added 6.6 million active users during the holiday quarter and finished the year with 179 million active accounts. PayPal also recently signed a strategic agreement with First Data, the largest domestic merchant processor, to accept its tokenized payments in retail stores.

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Three big challenges
Yet PayPal has three big weaknesses. First, companies with larger tech ecosystems -- like Apple, Facebook , and Amazon -- can throttle its user growth. Apple's expansion of Apple Pay into mobile browsers is especially dangerous, since Piper Jaffray estimates that at least 20% of PayPal's TPV came from iOS devices last year. Facebook's recent integration of social paymentsinto Messenger, which had 800 million active users at the end of 2015, threatens Venmo's growth, whileAmazon's recent integration of"Pay With Amazon" buttons withe-commerce storefronts might undermine PayPal's merchant services growth.

Facebook's P2P payments on Messenger. Image source: Facebook.

PayPal could also be left behind the tech curve by NFC (near field communications) payments. PayPal has been a big backer of Bluetooth and Internet-based payments, but Apple Pay and Android Pay are gradually turning NFC "tap to pay" payments into the industry standard. PayPal only recently announced that it would add NFC support to its Android app later this year.

Lastly, larger rivals could undercut PayPal's fee with lower rates. PayPal currently charges U.S. merchants 2.9% plus$0.30 for retail and peer-to-peer payments. The 1% to 3% interchange fee paid to credit card companies in card-linked transactions is included in that total. Apple doesn't charge merchants a set fee for Apple Pay. Instead, merchants only pay the standard interchange fee, which might be cheaper than PayPal depending on the card used. Apple then makes money by taking a 0.15% cut ofeach transaction from the credit card companies.

What do the valuations tell us?
PayPal stock currently trades at 39 timesearnings, which is much higher than the average P/E of 11 for the credit services industry. Analysts expect PayPal to grow its earnings 16% this year, giving it a forward P/E of 22. But since a stock is generally considered "fairly" valued if the forward P/E ratio matches its annual earnings growth rate, PayPal stock trades at a premium to next year's earnings.

Looking further ahead, analysts expect PayPal's earnings to grow 19% annually over the next five years, which gives it a 5-year PEG ratio of 1.4. Since a PEG ratio under 1 is considered "undervalued", we can't consider PayPal stock to be cheap relative to its long-term earnings growth potential. These elevated ratios all suggest that PayPal, which has an enterprise value of $44 billion, probably needs to get cheaper before being considered a viable takeover target.

The bottom line
PayPal has a big user base and a solid track record of double-digit sales and earnings growth, but past performance never guarantees future returns. The mobile payments market is getting increasingly crowded, and PayPal could lose customers to aggressive newcomers like Apple if it isn't careful. Therefore, I'd steer clear of PayPal for now, since its valuation seems too frothy for a company that faces so many near-term headwinds.

The article Is PayPal Holdings Inc. Overvalued? originally appeared on Fool.com.

Leo Sun owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com, Apple, eBay, Facebook, and PayPal Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.