Better Buy: Square, Inc. vs. PayPal

Image source: Square.

Both Square (NYSE: SQ) and PayPal (NASDAQ: PYPL) are market leaders in their respective fields of payment processing. Square is quickly growing its presence in brick-and-mortar small-business locations, while PayPal dominates online transactions.

At the same time, both have taken steps into each other's fields. Square expanded into e-commerce three years ago with Square Markets, and PayPal began appearing in physical stores with its PayPal Here card reader in 2012. Both offer digital peer-to-peer payments solutions with Square Cash and Venmo.

Investors interested in the payment processing space would be smart to look at both of these companies, but which company's stock is a better buy right now?

Growth vs. cash flow

Square and PayPal are in two very different places right now. Square is focused on expanding its presence in the market, bringing in larger customers, and growing its ancillary software and services business. It's burning cash to get there, and the results are expectedly lumpy.

PayPal has a singular focus -- free cash flow -- as a means to drive growth of the business. The company managed to increase free cash flow last year despite its spinoff expenses, and through the first half of 2016 it's increased free cash flow 48%.

Square's focus on growth is paying off. Revenue increased 46% through the first half of the year compared to 17% for PayPal. Granted, PayPal is operating off of a revenue base 8 times the size of Square's.

Square's strengths are seen in its focus on large businesses (greater than $125,000 in sales), which grew payment volume 61% last quarter. Businesses generating more than $500,000 in sales accounted for 14% of payment volume in the second quarter, double the share of two years ago.

Additionally, Square has been growing its higher-margin software and data product segment, which includes Square Capital and Caviar among other small add-on products like payroll management. Revenue from the segment was up 156% through the first half of the year, but still only accounts for 6.5% of revenue.

PayPal's focus on cash flow led it to make a deal with Visa (NYSE: V). The terms of the deal provide economic incentives for PayPal to push customers toward using their Visa credit cards through PayPal. However, if the incentives end up shifting fee-free bank transfers to Visa payments, PayPal will see pressure on its margins. Management will have to balance those forces in order to see benefits from the deal.

PayPal is also driving more transactions per customer and higher dollar amounts per transaction, which provides operational leverage. Transactions per account over the trailing 12 months increased 13% year over year to 29.4. Payment volume per transaction increased to $58.44 in the first half of the year, versus $57.14 through the first half of last year.

A look at valuation

Both companies are executing on their goals relatively well, but let's take a look at how the market is pricing each of their stocks.

PayPal currently changes hands around 4.5 times its trailing-12-month revenue. PayPal raised its 2016 revenue guidance to $10.75 billion to $10.85 billion with the release of its second-quarter results, so it trades for just 4.2 times the midpoint of its sales guidance.

Investors don't value Square's sales nearly as much as PayPal's. Its trailing price-to-sales ratio is just 2.6. That may be due to the impending drop in sales from the loss of the Starbuckscontract, which produced nearly 9% of revenue through the first half of the year. Square expects its 2016 net revenue to come in between $1.63 billion and $1.67 billion, implying a multiple of 2.4 times sales at its midpoint.

Square's revenue is much cheaper than PayPal's, but from an earnings perspective (which is what really matters to investors), it's much more expensive. Square doesn't currently produce any earnings, but it expects to produce positive adjusted EBITDA this year.

Square expects adjusted EBITDA between $18 million and $24 million for the year. At its midpoint, that produces an EV/EBITDA ratio of 176.7. By comparison, PayPal's EV/EBITDA ratio is just 19.6.

Even with its strong revenue growth and the turn toward positive earnings results, Square doesn't deserve a multiple that's 9 times higher than PayPal's. Until Square can show positive earnings growth that matches up to its valuation, PayPal remains the better buy.

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Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends PayPal Holdings, Starbucks, and Visa. 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.