Stock Analysis: Paychex (PAYX)

Company description:

Paychex is primarily a payroll processor, but is rapidly expanding its slate of human
resource capabilities to include retirement and health benefit administration, among other services. Substantially all of Paychex's revenue originates in the U.S. from small businesses with 17 employees on average, though it has a small presence in Germany. The firm operates about 100 branches to service its clients and is headquartered in New York.

Click here for a full description of company operations.

Financial highlights:

Revenue Growth (1-yr): 12.7%
Revenue Growth (4-yr average): 14.5%

Net Income Growth (1-yr): 11.0%
Net Income Growth (4-yr average): 15.5%

Free Cash Flow Growth (1-yr): 13.1%
Free Cash Flow Growth (4-yr average): 15.3%

Net Profit Margin (current): 27.3%
Net Profit Margin (5-yr average): 26.1%

Return On Equity (current): 28.6%
Return On Equity (5-yr average): 33.8%

Debt Ratio (current): 0.68
* The company has no long-term debt; it’s all current liabilities that company pays every year and is capable of paying them year-to-year as you can see from the Current Ratio below.

Current Ratio (current): 1.15

Discounted Cash Flow (DCF) Analysis:

I’ve used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 11% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that.

I used a discount rate of 10%, which is slightly below the default rate of 10.5% for an average company. At this time I’m using some of the defaults that Morningstar uses in their analysis (namely, a 3% perpetuity rate and 10.5% as the default discount rate) since I don’t have enough of investing experience to have meaningful rates of my own.

Using the assumptions listed above my intrinsic value of the stock is $38.37. My intrinsic value of Paychex is lower than what Morningstar has listed as a “fair value” for this company on its web site. The difference is mostly due to the fact that they judge this company as a “below average” risk and use 9% as the discount rate (I used 10%) while I think that this company is riskier than that (I think it has an “average risk”) due to uncertainty in the job market which would affect its revenue and earnings growth if unemployment rates were to increase.

Pros:

• A solid company with a long history of profitability and earnings growth
  
• Excellent financials: plenty of cash, no long term debt
  
• Expanding into other human resource offerings, which should fuel long-term growth
  
• High customer satisfaction (most of the marketing is done through word-of-mouth referrals)
  
• Paychex is more profitable than any of its competitors
  

Cons:

• Revenue and earnings growth have been slowing as can be seen in the last four quarters (and the last five years)
  
• Uncertainty in the job market could have adverse affect on the earnings
  
• Stock is currently overpriced according to my DCF analysis
  

Final decision:

At this time I will pass on this stock as being too expensive at $42 vs. $38 intrinsic value. Also, taking into account margin safety (this is a built-in padding in case my calculations are significantly off or stock market behaves even more irrationally than usually), my buying price range for this company would be between $27 and $19, which is 30% and 50% off the intrinsic value, respectively.