Better Buy: Square vs. American Express

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New digital payment providers like Square (NYSE: SQ) have been shaking things up in the payment space, but traditional payment providers like American Express (NYSE: AXP) are not going away. People still love their credit cards, and that means you don't necessarily have to chase the flashy new start-ups to find a good investment in the payments industry.

Let's take a look at where both companies stand in this matchup.

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Squared away

Square has had great success with its strategy of selling card readers to small merchants and then cross-selling those merchants additional services like payroll and accounting tools to help merchants grow their business. Since the company's IPO in 2015, the stock is up 430%, which gives Square a $29 billion market cap.

One of the main issues with Square is that it hasn't generated a profit. The company posted a rare profit of $20 million in the last quarter, but most of that was from unrealized gains on Square's equity investment in Eventbrite -- an online event planning service. Excluding that gain, Square lost about $17 million last quarter. However, the company has generated positive free cash flow of $71 million over the last year.

Management has made the decision to plow cash into growing the company, which is the main reason Square generally reports a quarterly net loss. Most of the company's expenditures go into product development and marketing.

Here is Square's performance on the top line through the first three quarters of 2018:

Metric 9 Months Ending Sept. 30, 2018 Change (YOY)
Transaction revenue $1.804 billion 29%
Subscriptions and services $398 million 129%
Hardware $50 million 71%
Total $2.366 billion 48%

Overall, the high growth rates Square continues to post across the business show that the strategy is working beautifully so far. Particularly encouraging is the 129% growth in subscriptions and services, which generates the highest gross margin. Also, the percentage of gross payment volume coming from larger sellers continues to grow year over year, which shows that small merchants continue to stick with Square as they grow their businesses.

Square is looking like a growth machine, but that growth currently comes at a steep price.

AmEx enters the fast lane

Shares of American Express are up 13% year to date and have outperformed the broader market. The company has posted strong results this year, as card spending is up and the number of AmEx cards in force continues to grow.

Metric TTM Through Sept. 30, 2018 Change (YOY)
Total revenue net of interest expense $36.164 billion 11%
Earnings per share $7.13 37%
Cards in force 115.1 million 2%
Average card member spending $19,235 6%

AmEx's double-digit growth in revenue over the last year is impressive since competition has been tightening. Digital payment providers and merchants are ramping up investment in their own payment solutions, which presents challenges for traditional card companies. But it's clear people still value the range of benefits and rewards that come with their AmEx card.

AmEx makes most of its money from charging merchants fees (called discount revenue) for accepting AmEx at point-of-sale. This is two-thirds of the company's total revenue, with annual fees from card members making up about 10%. In return for these fees, AmEx uses data and other services to help merchants grow their businesses.

It's this model of charging fees and reinvesting that revenue into valuable services for both merchants and card members that provides American Express with a strong competitive advantage. Management has been doubling down on spending to deliver more benefits and rewards for card members, which should eventually come back in the form of continued revenue growth.

Keep in mind, this could cause some margin pressure in the short term, especially if competition gets tighter, which would cause management to spend even more on benefits to attract card members.

However, even with the emergence of new digital payment solutions and the growing adoption of peer-to-peer payment apps, the company's performance this year says the AmEx brand is as relevant as ever and should be a good place to invest for the long term.

Which is the better buy?

I think both stocks would be great investments at the right price, so this decision boils down to valuation.

Square is obviously growing much faster, but after a run of more than 400% over the last three years, the stock trades at a frothy 100 times next year's earnings estimates. Taking growth into account, Square's PEG ratio still looks relatively high, at 2.74.

On the other hand, Amex is on pace to grow revenue 9% to 10% in 2018, while adjusted earnings per share should grow between 24% to 26% year over year. At a modest forward P/E of just 14 times next year's earnings estimates, AmEx shares have both near-term and long-term upside potential. Plus, AmEx shareholders get a dividend yield of 1.48%.

Considering all of this, I believe American Express is the better buy at current prices.

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John Ballard has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Square. The Motley Fool has the following options: short January 2019 $80 calls on Square. The Motley Fool has a disclosure policy.