February 20, 2020

Does Visa's (NYSE: V) premium quality justify its premium valuation?

Does Visa's (NYSE: V) premium quality justify its premium valuation?

You might not notice but the chances are you'll cross paths with Visa's services several times a day. The company is one of the world's largest payments networks with revenue of more than $20 billion in 2019. Here we'll go through Visa's financial reports and particularly focus on the return and margin aspects of its financial results, to gauge how strong the business is. A businesses quality is one of the most important traits that a company needs to possess, in order to generate a superior share price return over the long term so this will be illuminating.

Premium quality metrics

First, we look at Visa's Return On Equity (ROE) for the past 3 years. ROE (net income over shareholder equity), is one of the most important metrics for a long term investor to consider. It tells us how efficiently the company uses shareholder's money. A great company usually posts a better return on equity figure than the rest of the pack. The higher their ROE is, the better the company is at defending its competitive advantage. It is usually a result of providing superior quality products and services.

In its financial year 2019 (September 2018 to September 2019), Visa posted a return on equity of 35%. Normally a ROE of more than 20% is considered very good. Visa's 35% ROE suggested that the quality of its business is far superior to an average company.

More importantly, the upwards trend of its return on equity over the past several years tells us that Visa is increasing the quality of its business. In 2018 it posted a ROE of 30%, whereas in 2017 its ROE was around 20%. An increase of ROE suggests that Visa is strengthening its competitive advantage in its sector.

Source: Visa annual reports press release

At Genuine Impact, we calculate quantitative rankings for a universe of over 5,000 stocks globally, based on fundamental performance factors. For the Profitability ranking, which measures a company's ability to generate returns and cash flow, we look at a collection of underlying financial metrics such as return on equity, return on assets, return on invested capital and cash flow.

The chart below shows that Visa's 35% ROE in 2019 contributes to the Profitability ranking of #244 in our universe, as of Feb 19th 2020. It also shows that Visa's Profitability ranking has increased over time, thanks to the increase of ROE from 30.4% in 2018 to 35% in 2019.

Visa Profitability factor ranking 4th Feb 2019 - 19th Feb 2019. Source: Genuine Impact and Visa's annual statements.

Secondly we'll check out Visa's net profit margin (NPM) over the last 3 years. Like its trend of return on equity, the NPM margin has seen a healthy increase since 2017 as well. It posted a NPM of 52% in 2019 compared to 50% in 2018 and 37% in 2017.

Visa can reinvest this high level of profits back into the business to drive further growth. It also gives Visa the option to increase its dividend payment to shareholders if it chooses to.

Source: Visa annual reports press release

Even though return on equity and net profit margin are two very important metrics, there are a few other metrics we should also analyse. They include data points that tell us about Visa's financial strength, such as its net cash position on its balance sheet. In addition we should consider Visa's shareholder policy, such as its payout ratio and dividend growth history.

Visa's premium valuation

Based on its share price on Feb 14 2020, Visa is trading at a price to earnings ratio of 32x, when using a collection of earnings estimates by sell-side analysts for the next 12 months (next 4 quarterly earnings estimates). That is at a premium to the average 25x price to earnings ratio of all S&P500 stocks. Usually, when a company trades at a premium valuation, it is either thanks to better quality and/or higher growth. In Visa's case, it is obvious that Visa's quality financial metrics are strong enough to sustain the premium valuation multiple that Visa is enjoying.

How far can it go?

Comparing Visa to their close competitor MasterCard produces interesting results. Mastercard is a smaller company than Visa and they earned about 60% as much revenue as Visa — $12.5 billion — in 2018. So how does their return on equity (ROE) compare? Mastercard's ROE was at a very high 137% in 2019. That's almost 4x Visa's 35%, which is already high. The main cause of a difference in ROE figures is usually due to different business models and how two companies monetise their customer base.

Source: Visa and Mastercard annual statements

Mastercard's higher return on equity translates into a higher premium on its valuation. Its price to earnings ratio is at 37x, using the next 12 months' earnings estimates and its share price on Feb 14 2020. That is 5 points higher than Visa's 32x. It's clear that Mastercard enjoys a premium on its valuation compared to Visa's because of its higher quality performance, in this case its ROE.

Source: Refinitiv

What's next?

Above we went through Visa's return on equity and net profit margin to understand the quality of the business. There are other aspects of Visa which need studying in order to get the complete picture. These include metrics such as its net debt level, which tells us about the financial strength of Visa. The dividend growth history and dividend payout ratio, which tell us if Visa is rewarding its shareholders with good dividend policy. And free cash flow generation which tells us if Visa is generating enough cash from its businesses to fund its future growth, to name just a few.

Genuine Impact helps investors make better investments with analysis of securities fundamental performance data. Our comments above only consider historical data and don't take any current daily news and company press releases into consideration. We do not make recommendations or provide investment advice. Individual investors should make their own decisions or seek independent advice. To get in touch, email hello@genuineimpact.io.

Truman Du

Truman Du

CEO and Co-Founder

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