PayPal - The Return on Equity Story
In this release, we will break down PayPal’s ROE using the 5-step DuPont analysis.
Return on Equity measures the profitability that is generated for shareholders and is one of the fundamental ratios used by investors. Ultimately, if ROE is higher than the cost of equity, management is creating value for the shareholders.
A higher or increasing ROE demonstrates the efficiency of the company in converting shareholder equity financing into profits.
The formula of ROE is =>
Even though the ROE is a backward looking metric one should not ignore that ROE multiplied by the retention ratio leads to the Sustainable Growth Rate, which is the maximum growth rate a company can sustain using only internally generated profits.
1. PayPal’s reported ROE and Net income evolution:
Source: 10K reports, StockOpine analysis
2. ROE DuPont 5-step formula:
3. ROE analysis:
Source: 10K reports, StockOpine analysis
ROE: PayPal’s profitability seems to be improving since 2017, increasing its ROE from 11.7% in 2017 to 20% in 2021 with the exception of 2020, in which year the company recognized significant gains in the fair value of its strategic investments (ROE stood at 22.8%).
The Net income margin of PayPal was fairly constant over the years 2017-2019, however it increased to 19.6% in 2020 (as a result of the strategic investment gains) and subsequently declined to 16.4% in 2021 (still well above the period 2017-2019).
It shall be noted that over the period 2017-2019, Operating Margin declined from 17.3% to 15.7%, whereas from 2020 the company observed some improvement in operating margin reaching 17% in 2021. The decline was mainly driven by reductions in the take rates (from 2.87% in 2017 to 2.5% in 2019) and increases in transaction expenses as a percentage of revenues (from 33.7% in 2017 to 38.2% in 2019). In 2020 and 2021, there was still a decline in take rates to 2.29% and 2.04%, respectively, however, the transaction expense rate fell from 0.95% in 2019 to 0.85% in 2020 and 0.83% in 2021, being the main reason of the improvement in operating margin. For 2021 another factor for the improvement in margin was the release of $312m in credit losses which is not considered to be recurring.
Overall, the movements in margins state the obvious, i.e. the competition in the industry only gets intensified, but PayPal managed to grow while sustaining margins, demonstrating durability in its business model.
Management guided for a 20% Non-GAAP operating margin which per our estimates translates to an operating margin of c. 12-14%, which definitely is not a good sign but somehow makes sense considering the current economic environment and the growth expected from Braintree (higher funding cost).
Interest burden which also includes restructuring and other charges and gains/(losses) from strategic investments is fairly constant over the period, with the exception of 2020, where significant gains were observed in the strategic investments (further commentary in the financial leverage part).
Tax burden is also fairly constant except in 2021 where the company recognized a tax benefit.
Asset turnover and thus asset efficiency from 2020 onwards, showed a slight deterioration, which is not necessarily bad as PayPal acquired Paidy in 2021 for c.$2.7b and made four other acquisitions for a total of $542m, whereas in 2020 it acquired Honey for c.$4b. The consolidation has an additive effect on the assets, but the full potential of those acquisitions remains to be seen in future periods.
The final component of the ROE formula is the Financial Leverage which has a positive effect on the ROE of PayPal as it increased from 2.41 in 2017 to 3.5 in 2021. Taking more leverage could increase risk of default, however, as PayPal’s EBIT covers net interest expense by more than 24 times, no such threat exists. Adding more debt has a negative impact on net income as from a net interest income of $78m in 2017 it changed to a net interest expense of $175m in 2021.
4. Revised ROE and Net income
For better understanding of the ROE, we adjusted for the restructuring costs/other charges and gains/losses in strategic investments for the years 2017-2021 and normalized the credit losses of the years 2020 (which were elevated due to the pandemic) and 2021 (in which year there was a release in credit loss reserve). The resulting ROE shows a similar trend as the unadjusted ROE, increasing from 12.4% in 2017 to 18.5% in 2021.
Source: StockOpine analysis
PayPal consistently improved its ROE but the competitive environment is tough adding additional margin pressure to its operating profitability. This is not a threat that can go away overnight but PayPal can mitigate the impact on ROE through an improved asset efficiency and by minimizing costs that are fixed or semi-variable.
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