Concerns About Discover’s Card Charge-Off Rates Are Overblown

Shares of Discover Financial Services (NYSE: DFS) touched an all-time high of almost $82 recently, as the company gained from the ongoing rally across sectors with the implementation of the new tax code in the U.S. While the bank (which depends substantially on cards and payments) has seen its share price appreciate by more than 5% this year, this figure is well below the average gain of 9% seen across the U.S. banking sector as captured by the KBW Bank Index. We believe that the sub-par performance stems from the fact that investors remain wary of elevated charge-off rates among card lenders over recent quarters. Our view is reinforced by the fact that Capital One (which has a similar business model) has also seen its shares gain only around 5% over the month.

As we detailed in our interactive model, investors are justified in being wary of the downside to Discover’s share price from higher card charge-off rates. After all, an increase in this figure by 1 percentage point could knock off nearly 20% of the company’s value. But we believe that these fears are overblown. Card charge-off rates had fallen to historically low levels over 2014-15, and the visibly sharp increase in these figures since late 2016 was expected as the rates normalize. In fact, Discover’s card charge-off figure for full-year 2017 was identical to the average figure it reported for the period 2005-07 before the economic downturn. And we expect charge-offs to largely remain around current levels going forward, which is why me maintain our $90 price estimate for Discover’s stock. Our estimate is about 10% ahead of the current market price.

See our complete analysis for Discover

Discover’s Share Price Is Very Sensitive To Its Card Charge-off Rate

The correlation between the charge-off rate and the bank’s value is fairly intuitive, given the fact that about 80% of Discover’s loan portfolio consists of card loans which carry a much higher risk compared to collateral-backed loans like mortgages or commercial loans. We quantify the impact of changes in card charge-off rates on Discover’s share price using our interactive dashboard. You can modify assumptions such as earnings multiples, card balance, effective tax rate and others to see how sensitive Discover’s shares are to its card charge-off rate. A snapshot of our model is captured below:

As detailed in the chart above, an increase in Discover’s card charge-off rate by a single percentage point could reduce its 2018 EPS estimate by $1.40. Using the company’s current forward P/E ratio of 10.7, this represents a $15 decline in the bank’s share price – or a downside of more than 18%.

Charge-Off Rates Shouldn’t Increase Too Much In The Near Future

As we pointed out earlier, the jump in card charge-off rates over recent quarters was a due to the ongoing normalization in the figure. The unusually low loan provisions over 2014-15 were largely due to card lenders releasing some of the provisions they had set aside in the wake of the downturn. And the upbeat outlook for the U.S. economy in the near term should have a positive impact on charge-off rates going forward. Because of this, we expect Discover to incur card loan charge-offs largely around current levels going forward.

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