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PayPal Inc (PYPL) produced strong revenue and free cash flow (FCF) in Q4, but PYPL stock has fallen since its results were released on Feb 4. This could provide an opportunity for value investors based on its valuation.
PYPL was at $77.64 in midday trading on Friday, Feb. 7, down over 13% from $89.51 where it closed on Feb. 3.
In a recent Barchart article, I argued that PYPL stock was worth at least $105 per share (“Unusual Options Trades in PayPal Stock Shows Investors are Bullish" 1/15/25).
After PayPal's recent results, PYPL stock's value is even higher at $110 per share. This is based on its strong free cash flow (FCF) and FCF margins.
PayPal's Strong FCF Results
PayPal's revenue rose 4% in Q4 to $8.37 billion, which, according to Seeking Alpha, was $90.99 million higher than consensus estimates (i.e., +1.0% higher). Moreover, its strong free cash flow (FCF) came in much higher than even the company projected.
For example, last quarter PayPal said it expected to generate approximately $6 billion in free cash flow (i.e., see page 9 of Q3 earnings transcript). Here is what actually happened in 2024:
This shows that FCF was $6.77 billion, or over 10% higher than the company projected. Moreover, its adj. FCF margin rose significantly from 15.3% in 2023 to 20.9% in 2024.
The reason is that its Q4 FCF was significantly higher than last quarter. For example, it generated $2.1 in adj. FCF in Q4, on $8.366 billion in revenue. That means its Q4 adj. FCF margin was over 25.1%, much higher than its 2024 average of 20.9%.
This was also up from $1.5 billion in Q3, or 19.2% of its Q3 revenue. (This was also higher than the prior 12 months' adj. FCF margin of 17.3% in Q3, as I pointed out in my Dec. 29 Barchart article).
The bottom line is that PayPal has been squeezing out higher cash flow as its revenue rises. That is known as operating leverage. That is strong evidence of the company's underlying profitability which the market does not seem to recognize. There is also every reason to believe that this will continue.
Forecasting FCF for PayPal
For example, analysts now project that revenue in 2025 will rise to $33.08 billion this year, up 4.0% over 2024 ($31.8 billion). And next year it's projected to rise to $35.24 billion.
Therefore, if we assume that the company's adj. FCF margin will rise from 20.9% last year to 23% (up 10% YoY), the FCF could rise significantly:
0.23 x $33.08 billion = $7.61 billion adj. FCF estimate
That works out to 14.7% higher than last year's $6.634 billion in adj. FCF. The market may not fully appreciate this in its valuation.
Valuing PYPL Stock
The market is likely to value PYPL stock at least at a 6.67% free cash flow yield. This is the same as a multiple of 15x (i.e., 1/0.06667 = 15.0). This is the same as saying that if the company were to pay out 100% of its adj. FCF in dividends, the dividend yield set by the market would be 6.67%.
So, here is how that works out:
$7.61 billion adj. FCF / 0.0667 = $114.1 billion market value
That is 48% higher than today's market value of $77 billion at $77.96 per share. In other words, the stock's value is worth 48% more than $77.96, or $115 per share.
But just to be conservative, let's assume that the PYPL earnings just a 22% adj. FCF margin, or just 5% higher than in 2024. That implies its market value is worth $110 per share:
0.22 x $33.08 billion revenue = $7.277 billion adj. FCF
$7.277 b / 0.0677 = $109.1 billion mkt value
$109.1b / $77 b mkt value today = 1.417 = +41.7%
1.417 x $77.96 = $110.57 per share
The bottom line is that if PayPal's strong FCF margin growth continues, the stock is worth substantially more.
Analysts Agree
This is also what many analysts on Wall Street think. For example, Yahoo! Finance reports the average analyst target price is $95.02 from 44 analysts. Similarly, Barchart's mean price from analysts is $94.82. These surveys show that they think the stock is at least 21.6% undervalued.
Moreover, AnaChart.com, which focuses on recent analyst recommendations, shows that the average price target from 37 analysts is $98.99 per share, or a +27% upside from today.
One way to play this is to sell short out-of-the-money (OTM) puts. Another way is to buy long-term calls that are in the money (ITM), as I described in my Dec. 29 article.
Shorting OTM Puts
For example, look at the Feb. 28 expiration, which is three weeks away. It shows that the bid side premium for the out-of-the-money $75.00 put strike price is $1.24 per put contract.
That means that a cash-secured short-put investor can make an immediate yield of 1.653% (i.e., $1.24/$75.00).
This is what happens when an investor secures $7500 with their brokerage account and enters a trade order to “Sell to Open” 1 put contract at $75.00. The account will immediate receive $124 per contract shorted (i.e., 1.653% of the $7500 invested).
As long as PYPL stock stays over $75.00 in the next three weeks, the account will not be assigned to use the $7500 collateral to buy 100 shares at $75.00. Even if that happens, the investor has a lower breakeven of $75.00 - $1.24, or $73.76, or 5.4% lower than today's trading price.
This shows this is one good way to set a lower buy-in price target and still get paid while waiting. Note that the delta ratio is low at -0.30. That implies there is just a 30% chance, based on historical volatility in PYPL stock, that the stock will fall to this strike price.
The bottom line is that PYPL stock looks very undervalued. This is based on:
- its strong free cash flow and free cash flow margins
- operating leverage, which implies its FCF margins will rise as revenue increases
- analysts' price targets
- opportunities to short OTM near-term puts and buy long-term ITM calls.
