After a 245% rally since the March 23 lows of last year, at the current price of $92 per share, we believe Discover Financial Stock (NYSE: DFS) is trading around its near-term potential. Discover Financial, a leading credit card issuer in the United States and an electronic payment services company, has seen its stock rally from $27 to $92 off the 2020 March bottom compared to the S&P which moved around 75% – the stock is leading the broader markets by a huge margin and is trading 22% above its pre-Covid-19 peak in February 2020. The credit card giant has outperformed the consensus estimates for both revenues and earnings in each of the last two quarters. Further, it managed to boost its profitability in the fourth quarter driven by the reduction in provisions for credit losses on a year-on-year basis, suggesting some improvement in the loan repayment capability of its customers. Hence, the investor outlook is positive toward DFS stock.
Discover Financial’s stock has surpassed the level it was at before the drop in February 2020 due to the coronavirus outbreak becoming a pandemic. This seems to make it fully valued as, in reality, revenues are unlikely to see a significant boost as compared to the last year.
While the company’s total revenues rose around 12% from $9.9 billion in 2017 to about $11.1 billion in 2020, this translated into a 46% decrease in the net income figure. The difference in growth numbers is mainly due to a jump in operating expenses as a % of revenues from 38.2% in 2017 to 40.8% in 2020, primarily due to higher compensation costs. This reduced the net income margin from 20.5% to 10% in 2020.
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The company has seen steady growth in revenue over 2017-2020, and its P/E multiple has increased. We believe the stock is trading close to its near-term potential and is likely to trade sideways despite the recent growth and the potential weakness from a recession-driven by the Covid outbreak. Our dashboard “What Factors Drove 20% Change In Discover Financial Stock Between 2017-End And Now?” has the underlying numbers.
Discover Financial’s P/E multiple has changed from around 14x in FY 2017 to close to 25x in FY 2020. While the company’s P/E is just below 26x now, there is not much scope for downside when the current P/E is compared to levels seen in the past years – P/E multiple of around 25x at the end of 2020.
So Where Is The Stock Headed?
Discover Financial suffered in 2020 due to the global economic slowdown and the Covid-19 crisis, which reduced the consumer spending levels and increased the risk of loan defaults. The company reported $11.1 billion in total revenues for the year – down 3% y-o-y. This could mainly be attributed to a 4% y-o-y decline in the credit card business, which contributed around 76% revenues in 2019. This was driven by a drop in outstanding credit card loans and interest rate headwinds. Further, the credit card purchase volume also decreased 2% in the year due to lower consumer spending levels. While a recovery in the economy is likely to improve outstanding loans and purchase volume, interest rates are unlikely to see a swift revival to the pre-Covid-19 level anytime soon. Overall, Discover Financial revenues are unlikely to see a significant jump in FY2021. That said, DFS suffered a 62% y-o-y dip in its adjusted net income in 2020, mainly due to higher operating expenses and an increase in provisions for credit losses – the company increased its provisions to neutralize the higher risk of loan defaults. However, with the expected mass availability of the Covid-19 vaccine and anticipated recovery in the economy, the provision for credit losses is likely to see a favorable decrease in FY2021, boosting DFS’ profitability. Altogether, Discover Financial stock is likely to trade sideways in the short term.
The actual recovery and its timing hinge on the broader containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia. Following the Fed stimulus — which set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view. With investors focusing their attention on 2021 results, the valuations become important in finding value. Though market sentiment can be fickle, and evidence of an uptick in new cases could spook investors once again.
While Discover Financial Stock may have moved, 2020 has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how the stock valuation for Franklin Electric vs. Sherwin-Williams shows a disconnect with their relative operational growth. You can find many such discontinuous pairs here.