Better Buy: Square vs. Mastercard

Several converging trends appear to be increasing the use of electronic and digital payment methods, seemingly at the expense of cash. E-commerce sales, where credit card use is twice as high as transactions made in person, continue to outpace total retail sales in the U.S., according to the Census Bureau. Global e-commerce sales are expected to grow to $4.8 trillion by 2021, an approximate 75% increase over 2018's projected totals. Two companies poised to take advantage of this trend are Mastercard Inc (NYSE:MA) and Square Inc (NYSE:SQ). Let's take a closer look at each to determine which of these companies makes for a better investment today.

Both Mastercard and Square offer investors the chance to capitalize on the growing trend of the digitization of money. Image source: Getty Images.

The case for Square

In Square's 2018 fourth quarter, adjusted revenue rose to $464 million, a 64% increase year over year, and adjusted EBITDA grew to $81 million, a 97% increase year over year. The primary driver of Square's incredible growth remains its payment processing operations. In Q4, gross payment volume, the total amount of money processed by Square, grew 28% to $23 billion. Transaction-based revenue and profit rose 27% and 29%, respectively.

What's important to note, however, is that Square is no longer a simple smartphone attachment that accepts card and digital payments at the point of sale. It has developed a robust ecosystem that small businesses are increasingly using to run their entire businesses, including facilitating payroll, gaining immediate access to financing, booking appointments with customers, sending invoices, and setting up recurring payments -- to name just a few examples.

These services are accounted for in the company's subscription and services-based revenue, which continues to grow by leaps and bounds. In Q4, this segment saw revenue shoot up to $194 million, a 144% increase year over year. Even taking out the Weebly and Zesty acquisitions last year, the segment rose 112%. The growth was primarily driven by the Cash Card, Caviar, Instant Deposit, and Square Capital. These diverse features are not just driving revenue growth, but deepening Square's customers' dependence on the company's platform, making it more difficult for them to even consider leaving for a competitor.

The case for Mastercard

As a payments network, Mastercard makes its money by taking a small fraction of each transaction facilitated with one of its cards, whether literally or virtually. The company does not loan money to consumers -- that responsibility belongs to the issuing banks. The end result is an asset-light business model with high margins in a growing space that faces no credit liabilities -- nice!

In Mastercard's fourth quarter, revenue rose to $4.8 billion, a 15% increase year over year, and adjusted earnings per share (EPS) grew to $1.55, a 36% increase over last year's fourth quarter. The strong top- and bottom-line results were driven by growth in switched transactions, or the total number of transactions across Mastercard's network, and the total number of cards in circulation, which increased 13% and 5%, respectively.

Like Square, Mastercard is also working hard to deepen its relationships with its customers -- the financial institutions that issue its cards and the merchants that accept them. Through organic development and acquisitions, Mastercard has released a number of security, reward program management, and data analytics tools to supplement the core network service it provides. As financial institutions adopt these tools, it makes it more unlikely they will switch to rival Visa Inc (NYSE:V). In Q4, the "other revenues" segment, where these services are accounted for, rose to $996 million, a 17% increase over last year's quarter.

Final verdict? Look at the valuation

Full disclosure: I am bullish on both of these companies' futures, which is why both reside in my own personal portfolio. Square is becoming the commerce platform of choice for small brick-and-mortar business owners, as evidenced by its explosive growth rates. Mastercard sports an operating margin of 52.3%, incredibly high for a company its size. Better yet, the extra services it is developing give it a perfect place for the company to reinvest its profits back into its business.

While I like both companies very much, I own roughly twice as much, in real dollars, of Mastercard as I do Square. Why? Well, when comparing two companies that both show strong financial metrics with quality business models, I have to value each company's stock. In Mastercard's case, with a full-year adjusted EPS of $6.49, it has a P/E ratio of about 35. Not cheap, by any means, but for a company growing EPS at a 36% clip with high margins, within the ballpark of being fair.

Square's 2018 adjusted EPS was $0.46, giving the company a sky-high P/E ratio of about 170! In other words, while showing a much higher growth rate, it is evident that a lot of growth has already been priced into the stock. Of course, for a company just becoming profitable, the P/E ratio is not always the best way to value stocks. Yet, even when looking at the company's price-to-sales ratio, Square features a rich valuation.

There are a lot of good things to be said about each of these companies, and I personally believe both will beat the market in the years ahead. While Square can certainly appeal to growth investors willing to feature a little more risk in their portfolios, given the choice, I would invest in Mastercard over Square.