Paychex may come in handy

Paychex, (Nasdaq: PAYX), a payroll processor (and, increasingly, a human resources specialist), recently reported quarterly earnings, featuring net income up 12.6 percent. Management expects high single-digit sales growth in payroll revenue this year and a growth rate in the lower 20s for HR services.

The eminently scalable and high-quality business pushed its operating profit margin up 3.9 percentage points, far beyond the margins of rivals such as ADP, Intuit and Hewitt Associates.

You know what earning better margins on growing revenue means: markedly better profits. Operating income leapt 22 percent year over year in the third quarter. Even though declining interest rates hurt the bottom-line results, continued share buybacks concentrated the remaining profits among fewer shares outstanding, helping Paychex to grow its earnings per share by 18 percent.

Free cash flow may not be growing as fast as earnings (it’s up 12 percent year over year through the first three quarters of fiscal 2008), but at $525.8 million for the fiscal year to date, it continues to dwarf what Paychex reports as net income.

Relative to analysts’ sub-15 percent long-term profit growth projections, a P/E of 24 seems a bit much to pay. But relative to the company’s price-to-free cash flow ratio – a better measure of cash profitability – it’s a much closer call. Keep an eye on this one.

Ask the Fool

Q: I see that ExxonMobil hasn’t split its shares since 2001. Is that because it has too many shares outstanding already? – K.R., Martinsville, Ind.

A: It doesn’t typically work that way. Splits often take place when a stock’s price is deemed “too high.” Splits are, to some degree, a psychological event, making the stock look “cheaper” and possibly attracting more investors. If stocks never split, then a single share of some big companies such as Coca-Cola would cost as much as a car or house.

ExxonMobil does have a lot of shares – more than 5 billion. (Microsoft has more than 9 billion shares, while General Electric has roughly 10 billion.) But then its revenues and profits are huge, too. In 2007, it raked in more than $400 billion in revenues and netted a $40 billion profit. Per share, that’s $7.28. What really matters is how strong the firm is, how quickly it’s growing, how successfully it’s competing, and how each share’s value is increasing. Earnings per share for 2007 were up more than 400 percent over 1997 levels.

My dumbest investment

My worst investment was in a company that specialized in liquidation services, selling items on eBay. Based on the e-mail I received hyping it, I knew it was a pump-and-dump scam. I figured I would beat the criminals at their own game, make a few bucks, and run. I bought. I watched the price climb quickly. I didn’t take my eye off of my brokerage’s screen all morning, planning to sell at the first sign of weakness. I thought, “I’m so much smarter than these people!” Then it happened: My company’s server lost power. It took about 20 minutes to get my account back up. Guess who lost his shirt? I am an idiot! – Zac C., Denver

The Fool Responds: You’re playing with fire, dealing with easily (and frequently) manipulated penny stocks. People get excited, thinking they’ll get rich because they’re buying 10,000 shares for 5 cents apiece (costing just $500). But if the shares have been hyped up from one penny to five, they can easily and quickly plunge back to one – or below.