Discover Looks Even Better Following Stress Test

NEW YORK (TheStreet) -- Discover Financial Services (DFS) is a fascinating stock play for many reasons, including a high double-digit return on equity, a relatively low valuation and stock buybacks that have significantly reduced the firm's share count over the past few years.

And the buybacks are very likely to continue at a strong pace.

Discover for the first time has been included in the Federal Reserve's annual stress tests for large banks. The company passed the first round with flying colors, with a minimum Tier 1 common equity ratio of 13.2% through a "severely adverse" nine-quarter economic scenario. The first round of tests gauged 30 big banks' ability to remain well-capitalized with minimum Tier 1 common equity ratios of at least 5.0%.

The Fed will announce the results of the second round of tests -- called the Comprehensive Capital Analysis and Review, or CCAR -- Wednesday at 4 p.m. ET. CCAR runs the same severely adverse scenario, incorporating the banks' plans to deploy excess capital through dividend increases, share buybacks and/or acquisitions from the second quarter of 2014 through the first quarter of 2015.

Since the Fed limits the big banks to dividend payments of roughly 30% of earnings, the emphasis for the banks' announcements following the Fed's announcement will be on share buybacks. Many banks will announce impressive buyback plans; however, the buybacks only really help investors if they are large enough to lower the share count significantly when factoring in stock issuance for employee compensation.

According to data compiled by KBW, only Discover and State Street (STT) of Boston have followed through with net common-share buybacks large enough to lower their share counts by more than 5% in 2012 and 2013.

KBW analyst Sanjay Sakhrani estimates Discover on Wednesday will receive Federal Reserve approval for $1.6 billion in buybacks from the second quarter of 2014 through the first quarter of 2015, with estimated net buybacks of $1.365 billion, increasing from estimated net buybacks of $1.256 billion for the prior-year period.

State Street also seems likely to continue reducing its share count significantly. KBW analyst Robert Lee estimates the company will receive regulatory approval for $2.026 billion in common-share buybacks, with estimated net buybacks of $1.620 billion, down slightly from estimated net buybacks of $1.676 billion from the second quarter of 2013 through the first quarter of 2014.

But Discover looks to be the better buy for investors.

For starters, Discover trades for 10.5 times the consensus 2015 earnings estimate of $5.53, among analysts polled by Thomson Reuters, based on Monday's closing price of 57.84. The consensus 2014 EPS estimate is $5.19.

State Street closed at $70.21 Monday and traded for 12.3 times the consensus 2015 EPS estimate of $5.69. The consensus 2014 EPS estimate is $4.99.

Of course, it's not entirely fair to compare Discover and State Street, since the companies have completely different business models. Discover is primarily a credit card lender, but also boasts its own payment processing network, competing with American Express (AXP), Visa (V) and MasterCard (MA). State Street is a custody and trust bank, with a significant asset management business. Its main competitor is Bank of New York Mellon (BK).

A major feather in Discover's cap has been a return on tangible common equity (ROTCE) of 26.36% in 2013, down from 27.87% in 2012, according to Thomson Reuters Bank Insight. That compares to ROTCE of 18.59% in 2013 and 17.37% in 2012 for State Street. Those numbers are good, just not as impressive as Discover's, especially when considering the forward P/E valuations.

Discover's forward price-to-earnings ratio of 10.5 is one of the lowest among large-cap U.S. banks. An unfair example for comparison is Zions Bancorporation ZION, which failed the first round of the stress tests with a minimum Tier 1 common equity ratio of 3.6% according to revised results released by the Federal Reserve Monday. Zions Bancorporation's stock closed at $30.31 Monday and traded for 14.9 times the consensus 2015 EPS estimate of $2.03.

So why is Discover so cheap? One reason is that some analysts and investors believe the company hasn't been able to scale-up its payment processing business sufficiently for it to be a viable contender over the long term. There has even been speculation that the company could be a take-out target for one of the larger tech firms, such as Apple (AAPL), Microsoft (MSFT) and Google (GOOG), looking to boost their payment processing businesses.

But even if Discover were to be acquired, the purchase would likely feature a steep premium. So the take-out scenario is no reason not to consider the stock.

Despite the relatively low current valuation, Discover has outperformed. The shares have returned 4% this year, slightly ahead of the 3% increase for the KBW Bank Index (I:BKX). During 2013, Discover's stock had a total return of 46%, compared to a 35% return for the KBW Bank Index.

This chart shows the stock performance of Discover and State Street against the KBW Bank Index since the end of 2011:

DFS Chart data by YCharts

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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