Discover Financial Stock Has An 11% Upside Potential

[Updated 01/04/2022] Discover Financial Stock update

Discover Financial stock (NYSE: DFS) gained roughly 28% in 2021 and is trading around $119 currently. In comparison, the S&P500 rose 27% over the same period. That said, the stock has lost 3% in value since the third-quarter results. Trefis estimates Discover Financial’s valuation to be around $134 per share – approximately 11% above the current market price. The company posted better than expected results in the third quarter, with revenues slightly increasing on a year-on-year basis. While the net interest income (NII) and discount & interchange fees did witness some growth, it was partially offset by Unrealized Gains/ (Losses) on Equity Investments. The top-line has improved over the first nine months of 2021, and we expect the trend to continue in the fourth quarter. Notably, consensus estimates for fourth-quarter revenues and earnings are around $2.99 billion and $3.52, respectively.

The company’s top-line suffered a 3% y-o-y drop in 2020 due to lower NII and non-interest revenues. This was driven by the interest rate headwinds, a drop in consumer spending levels, and lower outstanding loans. That said, the economy has seen some recovery over the first three quarters of 2021. The company reported an 11% y-o-y increase in the cumulative nine months revenues to $9.15 billion. We expect the same trend to continue in the fourth quarter, enabling Discover Financial’s revenues to touch $12.1 billion in FY2021. Additionally, the adjusted net income margin is expected to increase from 10% to close to 43% in the year, primarily due to a favorable decrease in the provisions for credit losses. It is likely to result in an adjusted net income of $5.2 billion and an EPS figure of $18.01. This coupled with a P/E multiple of just above 7x will lead to the valuation of $134.

Below you’ll find our previous coverage of Discover Financial stock where you can track our view over time.

[Updated 11/11/2021] Is Discover Financial Stock Fairly Priced?

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 

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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