A Quick Look At Our $88 Price Estimate For Discover Financial Services

Discover Financial Services (NYSE:DFS) has done well over the years to carve out a name for itself in the extremely competitive card and payments industry. As one of just four major credit card processing companies in the U.S., Discover’s share of the market is just a fraction of market leader Visa’s. However, as one of just two companies which provide end-to-end payment services to customers and merchants (American Express being the other), and given its sizable exposure in the student and personal loans industry, Discover has a strong value proposition – especially taking into account the new avenues that have opened up due to technological advancements in the payments and lending spaces over recent years.

Discover’s steadily growing portfolio of credit card, student and private loans coupled with improving net interest margin figures will be the key drivers of value for the company in the future. Based on our interactive model for Discover, we estimate a fair value of $88 for the company’s stock. This price estimate is about 15% ahead of the current market price for Discover’s shares.

We arrive at our price estimate based on our forecast for 6 core value drivers for the company:

• Total Loans: This is the average size of Discover’s loan portfolio over a year, and includes outstanding card balances, student loans and personal loans. The card portfolio has grown from under $55 billion in 2015 to more than $62 billion in 2017, and we expect it to cross $67 billion in 2018. Student & personal loans were just shy of $16.5 billion in 2017, and we expect them to reach $17 billion this year. Taken together, this represents an increase in total loans for Discover from $78.5 billion in 2017 to almost $85 billion in 2018.
• Net Interest Yield on Loans: We arrive at this metric by dividing Discover’s Net Interest Income by the average value of its loan portfolio. The Fed’s ongoing rate hike process helped its net interest yield improve from 9.7% in 2015 to 10.2% in 2017, and we expect it to increase further to 10.3% in 2018. Using the net interest yield figure with the total loan estimate above, we arrive at our forecast for Discover’s net interest income in 2018 as follows:

• Total Network Volume: This is the total volume of payments processed by Discover over a year across its proprietary credit card network, its PULSE debit card network, Diners Club International network as well as other Network Partners. The total network volume declined from $312 billion in 2015 to under $307 billion in 2016 due to a sharp reduction in debit card transactions, before increasing to almost $336 billion in 2017 primarily due to an increase in proprietary credit card processing volumes. We expect volumes across Discover’s network services to trend higher in 2018 – helping this figure reach $375 billion.
• Fees as % of Network Volume: We arrive at this metric by dividing the sum of Discover’s discount fees, interchange fees and transaction fees by its Total Network Volume for a year. The metric was almost 0.41% in 2015, but declined steadily to 0.36% by 2017 as increasing competition from incumbents as well as new payment service providers resulted in an industry-wide decline in discount as we as interchange fees. As this trend will continue over the foreseeable future, we expect this metric to decline further to 0.35% in 2018. This allows us to estimate Discover’s payment services fees for 2018, as shown below:

• All Other Fees: This includes Discover’s revenues from originating loans and from protection products as well as other fees, and has averaged about $700 over the years. We expect this figure to remain around $700 million in 2018 – pointing to total revenues of $10.7 billion for Discover this year, as detailed below:

• Net Margin: This is the ratio of Discover’s net income to total revenues.  Notably, this figure fell from almost 26% over 2015-16 to 20.5% in 2017 due to a combination of a one-time increase in tax due to the U.S. Tax Act and a sharp increase in card provisions. There has been a noticeable jump in card charge-off rates over recent quarters due to the ongoing normalization in the figure across the industry. Loan provisions over 2014-15 were unusually low due to card lenders releasing some of the provisions they had set aside in the wake of the downturn. However, given the upbeat outlook for the U.S. economy in the near term, we expect Discover’s card charge-off rates to remain largely level going forward. Also, taking into account the lower effective tax rate under the new tax regime, we estimate a net margin of 25% for 2018.

As shown above, we forecast an EPS figure of $7.65 for Discover in 2018. Using our estimated P/E ratio of 11.5, this works out to a price estimate of $88 for its shares. This price estimate is more than 15% ahead of the current market price of $72 for Discover’s shares.

However, if you disagree with any part of our analysis, you can create your own model by making changes on our dashboard.

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