Where Will Mastercard Be in 5 Years?

Mastercard (NYSE: MA) has been one of the absolute best stocks to buy at almost any point during the past decade. In 2018, Mastercard's stock price has appreciated more than 29%, vastly out-performing the S&P 500 index, which has actually depreciated in price by over 2%. That outperformance holds true over the trailing 3-, 5-, and 10-year periods, with the gap widening the further one looks. But with the company's stock price appreciation has also come a stretched valuation. The company now trades at an adjusted P/E ratio of above 32. Using GAAP earnings per share (EPS), the valuation looks even more inflated.

It's only reasonable for investors to wonder if Mastercard's stock still makes a decent investment at these levels. However, rather than looking only at the company's latest quarter (which was actually quite good), or trying to ascertain who has the momentary upper hand in its perpetual fight with arch-rival Visa (NYSE: V), let's try to gaze out further into the future. Let's peer into our crystal ball and try to determine what the next five years might hold for Mastercard.

Does Mastercard have a durable moat?

An economic moat is a company's competitive advantage over business rivals that would look to take away the company's profitability and market share. While there are different types of economic moats, Mastercard has one of the most powerful: the network effect, which means a service or product gains in value the more it is used. In Mastercard's case, the more consumers who hold a Mastercard product, the more merchants will be compelled to accept Mastercard-branded cards as a payment method. Conversely, the more merchants that accept Mastercard products, the more consumers will be willing to have and use Mastercard products.

In fact, in one significant way, Mastercard's network effect is essentially doubled, because banks are unlikely to issue cards other than Mastercard or Visa in most geographic markets because of the network effect both enjoy with consumers and merchants. This means any potential competitor would need to overcome Mastercard's place with consumers, financial institutions, and merchants -- an awfully tall order!

Could this advantage disappear or deteriorate in the next five years? I find that unlikely. While it is always possible a cryptocurrency or blockchain-powered product used by banks could begin to displace Mastercard and Visa, those technologies are still in their infancy by comparison, and they would have to disrupt long-held consumer spending habits. Such products will not only need to be able to scale efficiently, but also gain the public's trust. That will take time.

The advantages to Mastercard's business model

Mastercard does not directly lend money to consumers; instead, that role belongs to the individual financial institutions that issue Mastercard products. Mastercard is merely the payments highway that consumer funds traverse when purchases are made using one of the company's cards. For providing a safe and quick journey for your money, Mastercard collects small fees. While almost microscopic on a transaction-by-transaction basis, these fees quickly add up due to the massive scale of Mastercard's network. In the company's third quarter, 2.47 billion cards were used to facilitate 18.83 billion transactions across its network.

This asset-light business model gives Mastercard a world-class operating margin of 59%. Mastercard's target for operating margin is 50%, a threshold that CEO Ajay Banga believes shows investors "that we are committed to running the company with a fair degree of efficiency and profitability." The company actually tries to not exceed that goal because management wants to continue to invest in growth opportunities, to continue to displace cash and checks in B2B transactions and invest in its growing services division.

Mastercard's services include everything from fraud prevention and data analytical tools to regulatory compliance assistance and reward program management. Accounted for under Mastercard's "Other Revenues," this segment's third-quarter revenue rose to $819 million, a 10% increase year over year. This quarter, Mastercard launched a new service, AML Insights, which helps banks comply with strict anti-money laundering regulations. The service is now live in the U.K. and will be rolled out to other geographic markets in the future.

In the company's third-quarter conference call, Banga explained the importance of continuing to invest in these services:

Mastercard's sustainable competitive advantage

As Banga explained, these services only increase Mastercard's advantage with the financial institutions that issue its products. For instance, how likely is it that a bank that issues Mastercard debit and credit cards will switch to a competitor if it also relies on Mastercard for its fraud prevention? These services make Mastercard's ecosystem that much stickier, making it much more difficult for financial institutions to leave the fold.

While it is impossible to predict the future with certainty, I believe Mastercard's moat will more than withstand the tests that the next five years throw at it -- and it might even emerge in a stronger position than it is in now. That's why Mastercard is one of the largest allocations in my own personal portfolio. Investors interested in companies with sustainable competitive advantages might want to consider it for their own.

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Matthew Cochrane owns shares of Mastercard. The Motley Fool owns shares of and recommends Mastercard. The Motley Fool owns shares of Visa. The Motley Fool has a disclosure policy.