Here's Why the Best Is Yet to Come for PayPal

By Matthew Cochrane Markets Fool.com

Investors in PayPal Holdings Inc (NASDAQ: PYPL) have certainly had reason to celebrate through the first five months of 2017. Since the beginning of the year, through May 19, shares in the payment platform had risen 25%. But with the sudden increase in price, some investors might wonder whether the best days are behind the payment platform -- at least in the short term.

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Some might think the company's valuation is a concern. Based on GAAP (unadjusted) earnings, PayPal's price-to-earnings ratio is a little over 42, well over the S&P 500's P/E ratio of approximately 25. With non-GAAP trailing-12-month earnings of $1.57, the company's adjusted P/E ratio is a little bit better at around 31.5, but still well above the market average.

Beyond its recent share price surge and relatively expensive valuation, it should be noted that PayPal operates in a tough neighborhood. Competition is fierce with smaller upstarts, deep-pocketed tech giants, and big banks all trying to carve out their piece of the payment industry's pie.

PYPL data by YCharts.

Despite these worries, I believe PayPal's bullish run is just beginning and has a long way to go before it ends. These are the factors that I believe are PayPal's biggest catalysts and will drive its growth for years to come.

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Paying on the go

Not exactly a breaking news alert: Americans like their smartphones...a lot! We like taking pictures with our phones and posting them online. We like sharing our thoughts with the world through our phones on a variety of social media platforms. We use our phones to remind us of important appointments and meetings, to surf the web, and, occasionally, even to call someone. Last, but not least, we are also starting to use our phones to buy things more than ever before. According to some estimates, mobile commerce might reach as high as $284 billion by 2020.

Image source: Getty Images.

PayPal believes it is primed to capitalize on this trend. Judging by the current growth the company is seeing in mobile payments, it's hard to argue with that assumption. In 2016, PayPal facilitated more than $100 billion in mobile payments and, if 2017's first quarter is any indication, that figure will grow enormously by the end of this year. In the first quarter, $32 billion of payment volume originated from a mobile device for the company, a 51% increase from last year's first quarter. That figure represents nearly a third (32%) of all payment volume processed by PayPal in the quarter.

What accounts for PayPal's success in mobile payments? One Touch. One Touch allows users to register a device with PayPal and then never have to enter log-in credentials or payment information on that device again. For phones, tablets, or PCs that are already password- or fingerprint-protected, this is a great option that makes the online or mobile shopping experience much more convenient. Retailers love it because it helps alleviate the problem of people beginning to make an online purchase but abandoning at some point during the process, presumably because the process was too long or inconvenient.

As PayPal management is quick to point out, One Touch is PayPal's most rapidly adopted program. At the end of the first quarter, over 53 million consumers had opted into the program and more than 5 million merchants accepted it at checkout.

Venmo's fast-approaching monetization

PayPal's popular peer-to-peer payment platform, Venmo, which people use to transfer money to friends, processed over $6.8 billion in payments last quarter, more than doubling its payment volume from 2016's first quarter. The payment app, which shares more than a few characteristics with social media platforms, is especially popular with millennials. Yet, up until this point in time, it has largely been a drag on PayPal's margins. This is about to change.

In last quarter's conference call, PayPal management stated they were ready to begin rolling out Pay with Venmo, the app that will allow users to make commercial transactions with their Venmo account. This means PayPal will finally start earning a cut from these transactions.

PayPal is also exploring advertising opportunities within the platform. At the Morgan Stanley 2017 Technology, Media, and Telecom Conference, COO Bill Ready stated merchants like Papa John's had already approached PayPal about engaging with Venmo users on their feeds. Due to Venmo's incredibly popularity, PayPal's management has rightly been cautious before experimenting with the user experience, but it certainly appears the day PayPal finally begins to make money from the Venmo platform is fast approaching.

Image source: PayPal Holdings Inc.

PayPal's network effect

PayPal's scale is showing signs that it is beginning to enjoy the advantages of a real network effect, where having more users becomes an advantage that builds on itself. In the first quarter, PayPal announced it had 203 million active accounts, a greater-than-10% increase year over year. With so many users, merchants are going to want to support the platform. It's no coincidence, then, that PayPal has more than 16 million merchant accounts. Of course, the more merchants that support the platform, the more attractive it is to more users...and the cycle continues. In the first-quarter conference call, CEO Dan Schulman discussed this advantage:

Our powerful two-sided network engages both consumers and merchants, and the larger our scale, the stronger our network effect becomes. We made meaningful progress in advancing merchant adoption of PayPal in the quarter. At the end of March, the number of active merchant accounts on our platform increased to 16 million. The size of our merchant base is a formidable competitive advantage and is extraordinarily difficult for others to replicate.

As with any stock, there's little doubt that investors in PayPal face real risk. Experienced investors know a lot can go wrong and drag down a company's share price. But I believe the risk-reward ratio skews heavily toward the investor when it comes to PayPal. Mobile commerce is a macro trend unlikely to subside anytime soon. Venmo's monetization could provide a noticeable boost to earnings as soon as next year. And the more PayPal's core platform grows, the more that growth will fuel even more growth. With these catalysts in place, I believe the best is yet to come for PayPal's shareholders.

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Matthew Cochrane owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool has a disclosure policy.