Discover Financial Services Is a Buy With Plenty of Upside

 NEW YORK (TheStreet) -- Why should investors buy into Discover Financial Services (DFS) ?

For the same reason the stock, at around $63, has moved 13% higher for the year to date: Discover's ability to increase total loan balances by nearly 7% over the year ago quarter coupled with its lucrative business of lending money to its credit card users.

The other reason to own Discover at this point is the stock trades at half the forward price/earnings ratio of its competitors MasterCard (MA) and Visa (V) . That inequity eventually will be recognized by analysts, which will be a catalyst for the stock to zoom higher over the next year.

Discover is gaining in the balance transfer department as balances have increased 6% during the latest quarter. As customers transfer credit card balances, Discover begins collecting generous interest income on these unpaid amounts which translates to earnings that fall right to the bottom line.

Non-card related lending is also expanding for the Riverwood, Ill., financial services giant. There's enormous growth potential when it comes to personal and student loans, which the company has indicated it will pursue.

Whether through competitive interest rates or smart incentive programs to attract new customers, the company has a knack for earning the confidence of clientele in many demographics. That contributed to Discover's ability to increase total loan balances by nearly 7% over the year ago quarter ending June 30.

Management knows that the current borrowing environment is flat to benign. That's why the company is pursuing prime-quality borrowers who pay their monthly minimums due. Also boosting the company's net interest income by more than 11% has been a healthy decline in the funding costs of its loans.

A company representative could not comment on Discover's plans by press time beyond providing links to the company's annual report and most recent investor day presentation.

From an investment perspective Discover Financial offers an operating margin of nearly 57% plus a profit margin of 35% that most companies only dream about. While earnings per share, by my estimates, should grow by 11% during the quarter ending September 30, the total 2014 EPS is likely to be up nearly 8%.

Keep in mind that shares of DFS offer investors a hearty 23% return on equity. By comparison Visa's ROE is only 20.5% while MasterCard leads the pack with a 55% ROE.

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The following one-year chart of its stock price shows the strong correlation with Discover's buoyant trailing 12-month diluted EPS.

DFS Chart DFS data by YCharts

DFS trades at a forward, one-year PE ratio of only 11. Compared to MasterCard's forward PE of 21, Discover Financial looks undervalued, plus the dividend yield of 1.51% is much better than MasterCard's puny 0.56% yield.

Discover is counting on expanding its free checking product that offers a reward for each check the customer writes. At the same time, its online savings accounts should continue to attract new deposits that stick around, helping to drive funding costs lower.

The company anticipates more growth ahead especially with non-credit-card loans, which are expected to increase at double the rate of credit card balances. With the majority of its loans originated with a floating rate, every percentage point interest rates rise boosts Discover's net interest income by about 2%.

In spite of its stock's stellar performance this year I expect plenty of additional upside with my one-year price target at $76. Remember, DFS trades at about half the forward PE of its competitors, which from my perspective will be revised upward in favor of Discover Financial.

At the time of publication, the author was long DFS, although positions may change at any time.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


TheStreet Ratings team rates DISCOVER FINANCIAL SVCS INC as a Buy with a ratings score of A+. TheStreet Ratings Team has this to say about their recommendation:

"We rate DISCOVER FINANCIAL SVCS INC (DFS) a BUY. This is based on the convergence of positive investment measures, which should help this stock outperform the majority of stocks that we rate. The company's strengths can be seen in multiple areas, such as its revenue growth, solid stock price performance, growth in earnings per share, increase in net income and good cash flow from operations. We feel these strengths outweigh the fact that the company has had somewhat disappointing return on equity." You can view the full analysis from the report here: DFS Ratings Report

Marc Courtenay is a financial research analyst and the founder of Advanced Investor Technologies LLC as well as the publisher and editor of www.ChecktheMarkets.com.

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