Better Buy: Square vs. PayPal

While recent market volatility has taken a bite out of Square's (NYSE: SQ) and PayPal Holdings' (NASDAQ: PYPL) returns, both stocks have vastly outperformed the broader S&P 500 index this year. Square, best known for its growing suite of commerce and payment solutions for small businesses, has seen its stock appreciate 83% year to date. Shares of PayPal Holdings, the digital-wallet platform with 254 million active accounts, have increased by a more modest 18%, but still far higher than the index's negative 2% return on the year.

What makes comparisons between these two payments companies particularly intriguing is that each is increasingly encroaching on the other's core markets. Square's Cash App offers most of the same capabilities as PayPal's core platform and Venmo, with a few added exclusive features to boot, such as buying and selling bitcoin.

Meanwhile, PayPal is making acquisitions and organically improving its point-of-sale and online offerings to attract more businesses to its ecosystem. Let's take a closer look at each to see if we can determine which makes for a better investment now.

The case for Square

The last time investors got an update on the number of Square's Cash App users was in its 2017 fourth-quarter shareholder letter, when the company stated it had 7 million active users as of December 2017. Of course, using other measuring sticks, we know the app has grown rapidly since then: Cumulative Cash App downloads surpassed Venmo downloads this past summer, according to Nomura Instinet analysts.

The Cash App, originally used for digital peer-to-peer payments, now offers a much more robust set of services. In fact, Square CEO Jack Dorsey says many of its users are using Cash App as they would a bank account. In the company's 2018 third-quarter conference call, Dorsey talked about how the company views Cash App:

One way both PayPal and Square have increased engagement with users is by introducing plastic spending options. For Square, this meant launching its own debit card, the Cash Card. By June 2018, Cash Card holders spent $250 million, almost tripling the card's monthly spending since its debut in December 2017. This level was reached just one month after Square introduced Cash Boost, a rewards program giving cardholders discounts when using their Cash Cards at participating merchants.

Square continues to show explosive growth. In the company's third quarter, adjusted revenue rose to $431 million, a 68% increase year over year, while adjusted EBITDA rose to $71 million, an incredible 107% increase year over year. This amazing growth comes with a hefty price tag though: Based on its adjusted revenue, Square's price-to-sales ratio (its market cap divided by trailing-12-month revenue) is about 15.5, a premium price if there ever was one.

Of course, Square's Cash App is just one aspect of the company's growing payments empire. The core payment transactions segment continues to be the leader in terms of revenue, but Cash App is where Square is directly treading on PayPal's core competencies.

Now let's look at how PayPal is going after Square's core market.

The case for PayPal

PayPal has a long history of serving merchants, dating back to its eBay days when it facilitated transactions between the site's millions of sellers and buyers. In 2013, while still owned by eBay, PayPal acquired Braintree, a platform that allows merchants to accept mobile and in-app payments, for about $800 million. With the Braintree addition, PayPal's competitive positioning with online merchants changed dramatically, and the company soon scored some big clients, including OpenTable, StubHub, and Uber. Still, PayPal didn't make major inroads with point-of-sale solutions for traditional retailers until earlier this year.

PayPal began seriously courting merchants this year when it acquired iZettle, informally known as "the Square of Europe," for $2.2 billion. iZettle offers smaller European merchants the capability to accept card payments with a mobile device, much like Square first did in the United States. PayPal followed up the iZettle addition with three more acquisitions, all designed to bolster the services it could offer merchants.

Soon after PayPal welcomed these new companies under its corporate umbrella, it fired a shot across Square's bow when it announced it would offer Funds Now, a free service to merchants allowing them to access their money immediately after making a sale. Square offers the exact same service, called Instant Deposit, but charges an additional 1% of the seller's sale for the privilege.

In PayPal's third quarter of 2018, revenue grew to $3.68 billion, a 14% increase year over year, and adjusted earnings per share (EPS) rose to $0.58, a 26% increase year over year. While that growth isn't as explosive as Square's, PayPal's valuation is a bit more reasonable. Based on its adjusted EPS, the company trades at a P/E ratio of about 38 -- a definite premium to the broader market's valuation, but reasonable given PayPal's strong growth. PayPal's price-to-sales ratio is about 6.1, a significant discount to Square's stratospheric valuation.

The verdict

Both Square and PayPal reside in my portfolio at over 4% allocations. I believe both companies stand a good chance of giving shareholders returns that handily beat the market over the next five years. Both operate in expanding markets and have demonstrated competitive advantages against business rivals. However, as they continue to face off more directly against each other in the coming years, that might begin to change. So, if forced to choose just one of these as an investment today, I would go with PayPal based on its more reasonable valuation.

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Matthew Cochrane owns shares of PayPal Holdings and Square. The Motley Fool owns shares of and recommends PayPal Holdings and Square. The Motley Fool has the following options: short January 2019 $82 calls on PayPal Holdings and short January 2019 $80 calls on Square. The Motley Fool recommends eBay. The Motley Fool has a disclosure policy.