Is Discover Financial Stock Fairly Priced?

+42.69%
Upside
96.78
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Trefis
DFS: Discover Financial Services logo
DFS
Discover Financial Services

Discover Financial stock (NYSE: DFS), the credit card giant, has gained 30% YTD – up from its value of $91 at the beginning of 2020 to around $117 currently, outperforming the S&P500, which grew 24% over the same period. Further, the company’s net interest income (NII) and discount and interchange fees for the first nine months of 2021 have improved 3% and 27% y-o-y, respectively.

There were two clear reasons behind this: First, easing of travel bans and Covid-19 restrictions benefited the consumer spending levels. Second, favorable funding costs.

But we believe there is more upside to come over the coming months 

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Trefis estimates Discover Financial’s valuation to be around $134 per share – about 14% above the current market price – based on one key opportunity and one risk factor.

The opportunity we see is Discover Financial Revenues growth over the subsequent quarters. The company generates more than 90% of its total revenues from the direct banking segment. Out of which close to 85% of the share comes from NII. The NII suffered a 2% y-o-y drop in 2020, due to lower outstanding loans and interest rate headwinds. Further, the non-interest revenues decreased 7% y-o-y due to lower discount and interchange fees. This restricted the firm’s revenues to $11.1 billion in 2020 – down 3% y-o-y. That said, the pattern has changed in FY2021. The company recently released its third-quarter results, outperforming the consensus estimates for revenues and earnings. It posted total revenues of $2.8 billion – up 2% y-o-y, driven by a 6% growth in the NII and 26% increase in the discount & interchange fees. Notably, the top-line was partially offset by -$167 million Unrealized Gains/ (Losses) on Equity Investments. Overall, the NII and discount & interchange fees both have seen some improvement over the first three quarters of FY2021. The cumulative NII for the first nine months improved 3% y-o-y, primarily driven by favorable funding costs due to lower market rates and decreased interest charge-offs. Further, the discount & interchange fees grew 27% y-o-y over the same period, mainly due to higher transaction volumes. 

Moving forward, we expect the same trend to continue in the last quarter of FY2021. Overall, it will likely enable Discover Financial’s revenues to touch $12.1 billion in FY2021. Our dashboard on Discover Financial Revenues offers more details on the company’s segments.

Discover Financial’s profitability numbers suffered in 2020 due to sizable build-up provisions for credit losses and higher expenses as a % of revenues. However, the company has reduced its provisions figure in 2021, due to improvement in the loan repayment capability of its customers. Altogether, the adjusted net income margin is likely to improve from 10% to around 43% in the year, leading to a net income of $5.2 billion. It is likely to result in an EPS of $18.01, which coupled with the P/E multiple of just below 8x will lead to a valuation of around $134.

Finally, how much should the market pay per dollar of Discover Financial’s earnings? Well, to earn close to $18.01 per year from a bank, you’d have to deposit about $1801 in a savings account today, so about 100x the desired earnings. At Discover Financial’s current share price of roughly $117, we are talking about a P/E multiple of just below 7x. And we think a figure closer to 8x is appropriate.

That said, credit card issuance and electronic payment solutions appear as a risky business right now. Growth looks less promising and near-term prospects are less than rosy. What’s behind that?

Discover Financial is heavily dependent on net interest income and consumer spending levels. While the NII has seen some recovery due to lower funding costs, the company has posted stagnant growth in the outstanding loan balances. This has restricted the growth potential of NII in the near term. Further, consumer spending levels have improved over the recent quarters. However, any sudden uptick in the number of Covid cases or worsening of the economic conditions can hurt the current trend. To sum things up, we believe that Discover Financial stock is undervalued. 

 

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