Buy This Dirt Cheap Credit Card Stock Now

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Discover Financial Services' (NYSE: DFS) card doesn’t have as strong a brand in the eyes of consumers as those of its competitors, such as Visa Inc (NYSE: V), Mastercard Inc (NYSE: MA), or American Express Company (NYSE: AXP), but it has paid off the most for investors so far this year. The stock is up over 60%; Visa’s is closer to 30%, while the other two card issuers have risen about 20% in 2012. In late September, Discover announced that it had earned $1.21 per share in its quarter ending in August (the company’s fiscal year ends in November). This not only topped analyst expectations, but also beat the $1.18 in earnings per share from the same quarter in 2011; while net income was actually lower, significant buybacks caused EPS growth to be positive. Revenue was also up, by about 10%.

Annualizing the $1.21 in earnings per share would yield a P/E multiple of 9, cheap for a company that seems like it should be able to continue earnings per share due to transaction volume and buybacks. Wall Street analysts expect a decline in EPS next fiscal year, and so the forward earnings multiple based on their estimates rises to 10. However, over the longer term the sell-side is bullish on Discover Financial Services, and so the five-year PEG ratio, which considers the company’s value prospects in the context of growth, comes out to 0.9.

The largest position in Discover Financial Services at the end of June in our database of 13F filings was the 5.7 million shares owned by Donald Chiboucis’s Columbus Circle Investors. Columbus Circle increased its position in the summer of 2011 and so has benefited from the rise in price; the 12% cut in its stake may merely be the fund taking profits on its investment (Find more stocks Columbus Circle owns). Billionaire Ken Griffin’s Citadel Investment Group owned 3.6 million shares of Discover at the close of the second quarter, which was a large increase from its position at the beginning of April (see more stock picks from billionaire Ken Fisher).

Visa and Mastercard made our list of the ten most popular services stocks among hedge funds for the second quarter of the year (see the full list), and are probably the most widely held peers for Discover. Visa trades at 19 times forward earnings estimates, and Mastercard trades at 18 times. Those figures are remarkably higher than where Discover trades, and while these companies have better brands, we don’t think they deserve that much of a premium. The dividend yields of these three companies aren’t very significant, but Discover’s is highest in any case. Finally, the revenue growth rates that Visa and Mastercard showed last quarter compared to a year earlier cluster around 10%--essentially no difference from Discover. Therefore, we think that even after its rise Discover trumps the market leaders.

Two other credit card issuers are American Express, also mentioned earlier, and Capital One Financial Corp. (NYSE: COF). These companies trade at earnings multiples considerably closer to Discover’s. American Express carries trailing and forward P/Es of 13 and 12, respectively; Capital One is priced at 11 times trailing earnings and only 8 times forward earnings estimates. Capital One looks about as cheap as Discover, and at a bit of a discount if you take the Street’s estimates at face value, but its revenue was down in its most recent quarter versus a year ago and its earnings nearly disappeared entirely. We think Discover is a better buy here as well. American Express’s business has been about flat, and we would say it has a better brand than Discover that justifies something of a price premium. With it being cheaper than Visa or Mastercard, it is the only peer that we would say looks about even with Discover as an investment. 

This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article.The Motley Fool owns shares of MasterCard and has the following options: short OCT 2012 $55.00 puts on American Express Company, short OCT 2012 $60.00 calls on American Express Company, and long OCT 2012 $65.00 calls on American Express Company. Motley Fool newsletter services recommend American Express Company and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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