At $87, Discover Financial Stock Is Still Undervalued

[Updated 02/04/2021] Discover Financial Valuation Update

Despite more than 200% gain since the March 23 lows of the last year, we believe that Discover Financial stock (NYSE: DFS) has some more upside potential. Trefis estimates Discover Financial’s valuation to be around $95 per share – approximately 10% above the current market price. Discover Financial is a leading credit card issuer in the United States and an electronic payment services company. It outperformed the consensus estimates in the recently released fourth-quarter results. DFS reported revenues of $2.8 billion, which was 4% less than the previous year. This could be attributed to a 2% y-o-y decrease in net interest income due to lower average receivables and an unfavorable net impact from lower market rates, followed by a 14% drop in non-interest revenues. However, it still managed to boost its EPS figure by 15% y-o-y, driven by lower provisions for credit losses on a year-on-year basis.

The coronavirus outbreak and global economic meltdown have negatively impacted Discover Financial’s top-line in 2020, as people were more focused on essentials rather than discretionary and leisure expenses. The lower consumer spending levels resulted in a decrease in credit card loans and a drop in card purchase volume – credit card business (76% revenue share in 2020) suffered a 4% y-o-y decline in the year. Further, its net interest margin decreased due to the lower interest rate environment. Altogether, this led to a 4% y-o-y drop in full-year 2020 revenues, restricting it to $11.1 billion. That said, the consumer spending levels have improved over the recent quarter and we expect the trend to continue in the coming months. It is likely to benefit the company’s top-line, enabling Discover Financial’s revenues to touch $11.5 billion in FY 2021.

Discover Financial reported a 62% y-o-y drop in its adjusted net income for 2020, due to higher operating costs and a significant increase in its provisions for credit losses. Due to the Covid-19 crisis, the loan repayment capability of its customers deteriorated, increasing the risk of loan defaults. DFS increased its provisions from $3.23 billion to $5.13 billion in 2020 to cater to that risk. This reduced the EPS figure from $9.09 in 2019 to $3.60 in 2020. However, as the economy moves toward normalcy, the loan repayment capability of its customers is expected to improve, resulting in a favorable decrease in the credit loss provisions. Additionally, it is likely to start its share repurchase program in 2021. This will likely enable the EPS figure to touch $8.98 in FY2021. Overall, the EPS of $8.98 coupled with the P/E multiple of just below 11x will lead to a valuation of around $95.

[Updated 08/21/2020] Despite 90% Jump, Discover Financial Stock Can Still Grow

Discover Financial stock (NYSE: DFS) lost close to 68% – dropping from $84 at the end of 2019 to around $27 in late March – then spiked almost 90% to around $51 now. Despite the recent rally, the stock remains 40% below the level seen at the beginning of the year.

There were 2 reasons for this: The Covid-19 outbreak and economic slowdown meant that market expectations for 2020 and the near-term consumer demand dropped. As the company is heavily dependent on the credit card segment and other loans business, this could lead to sizable losses due to an expected spike in loan default rates. The multi-billion-dollar Fed stimulus provided a floor, and the stock recovery owes much to that.

But this isn’t the end of the story for Discover Financial’s stock

Trefis estimates Discover Financial’s valuation to be around $59 per share – about 15% above the current market price – based on an upcoming trigger explained below and one risk factor.

The trigger is an improved trajectory for Discover Financial’s revenues over the second half of the year. We expect the company to report $11.1 billion in revenues for 2020 – around 4% lower than the figure for 2019. Our forecast stems from our belief that the economy is likely to open up in Q3. Consumer spending in the U.S increased by 8.5% m-o-m in May and then 5.6% m-o-m in June (July data is not out yet). If the trend continues in the coming months, it is likely to result in higher loans and growth in transaction volume – credit card business contributed around 76% of the company’s total revenues in FY 2019. This, in turn, would benefit the revenue trajectory over the coming months. However, net income for the year is expected to drop to $1.1 billion – down 62% y-o-y, mainly driven by higher provision for credit losses, reducing the EPS figure to $3.63 for FY2020.

After that, Discover Financial’s revenues are expected to improve to $11.4 billion in FY2021, mainly driven by growth in outstanding credit card loans and higher transaction volume. Further, the net income margin is likely to improve as compared to the previous year due to a decline in provisions for credit losses, leading to an EPS of $5.94 for FY2021.

Finally, how much should the market pay per dollar of Discover Financial’s earnings? Well, to earn close to $5.94 per year from a bank, you’d have to deposit around $650 in a savings account today, so about 110x the desired earnings. At Discover Financial’s current share price of roughly $51, we are talking about a P/E multiple of just below 9x. And we think a figure closer to 10x will be appropriate.

That said, consumer finance is a risky business right now. Growth looks less promising, and near-term prospects are less than rosy. What’s behind that?

Discover Financial has a sizable portfolio of consumer loans – around $91 billion in FY2019 out of which close to $73 billion were in credit card loans alone. The economic slowdown is likely to harm the financial health of many customers, exposing the company to potential loan defaults. In anticipation of that, Discover Financial has increased its provisions for loan losses to around $3.9 billion by Q2 2020– around 2.4x of the year-ago period, leading to a significant jump in the total expenses figure for the year. If the economic condition continues to worsen, this figure could further increase in the coming months.

The same trend is visible across Discover Financial’s peer – American Express. Its revenues are likely to suffer in FY2020 due to lower consumer spending and its net income margin is likely to drop due to a jump in provisions for credit losses in anticipation of loan defaults. Further, American Express’ stock currently has a stock price of over $97 but looks slated for an EPS of around $6.66 in FY2021.

What if you’re looking for a more balanced portfolio instead? Here’s a high quality portfolio to beat the market, with over 100% return since 2016, versus 55% for the S&P 500. Comprised of companies with strong revenue growth, healthy profits, lots of cash, and low risk, it has outperformed the broader market year after year, consistently.

See all Trefis Price Estimates and Download Trefis Data here

What’s behind Trefis? See How It’s Powering New Collaboration and What-Ifs For CFOs and Finance Teams | Product, R&D, and Marketing Teams