Discover Financial Stock Is Undervalued

Discover Financial stock (NYSE: DFS) has lost roughly 11% YTD, as compared to the 12% rise in the S&P500 over the same period. Further, at its current price of $87 per share, it is trading 22% below its fair value of $112 – Trefis’ estimate for Discover Financial’s valuation.

Interestingly, Discover Financial stock had a Sharpe Ratio of 0.3 since early 2017, which is lower than 0.6 for the S&P 500 Index over the same period. This compares with the Sharpe of 1.24 for the Trefis Reinforced Value portfolio. Sharpe is a measure of return per unit of risk, and high-performance portfolios can provide the best of both worlds.

The credit card giant posted mixed results in the second quarter of 2023, with revenues beating the consensus but earnings missing expectations. It reported net revenues of $3.88 billion, which is 21% y-o-y more than the year-ago period. It was driven by a 22% growth in the net interest income (NII), followed by a 16% rise in the non-interest revenues. The NII was up due to an increase in outstanding loan balances, along with higher interest rate margins. Notably, the NII contributes around 80% of the top line. On the expense front, provisions for credit losses witnessed an unfavorable increase from $549 million to $1.3 billion in the quarter. It resulted in an 18% drop in the adjusted net income to $895 million.

The company’s net revenues grew 25% y-o-y to $7.62 billion in the first half of FY 2023. It was primarily because of a 24% jump in the net interest income, thanks to higher interest rates and loan growth. Further, total payments volume – a key metric, improved by 9% y-o-y over the same period. On the cost side, the provisions figure witnessed a significant build-up, leading to a 20% y-o-y decline in the adjusted net income to $1.83 billion.

Moving forward, we expect the same trend to continue in the third quarter. Notably, the consensus estimates for Q3 2023 revenues and earnings are $3.94 billion and $3.19 respectively. Overall, Discover Financial’s revenues are estimated to touch $15.61 billion in FY2023. Additionally, DFS’s adjusted net income margin is likely to drop in the year, leading to an adjusted net income of around $3.28 billion in the year. This coupled with an annual EPS of $12.84 and a P/E multiple of just below 9x will lead to a valuation of $112.

[1] Month-to-date and year-to-date as of 10/4/2023
[2] Cumulative total returns since the end of 2016

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