Discover Financial Services Quarterly Valuation – November 2014

In the wake of the great financial crisis it can sometimes be difficult for Intelligent Investors to find a solid financial company in which to invest, because they require specific achievements over the historical period.  Many investors may simply decide to throw out the worst years with the rationale that they are outliers that shouldn’t be considered when evaluating the company’s prospects, but doing so would involve speculation.  We don’t know whether the financial crisis will happen again, but we do know that if it does, we can expect to see similar results as we did before.  By continuing to require the same standards for the historical period, Intelligent Investors are able to whittle down banks to only those with the best financial position, and then they are able to determine an intrinsic value to get a sense of whether the company is a good investment.  In addition, a company must have strong financial statements to prove that it is stable enough for Intelligent Investors.  This is best done by utilizing a systematic approach to analysis that will provide investors with a sense of how a specific company compares to another company.  By using the ModernGraham method one can review a company’s historical accomplishments and determine an intrinsic value that can be compared across industries.  What follows is a specific look at how Discover Financial Services (DFS) fares in the ModernGraham valuation model.

Company Profile (obtained from Google Finance): Discover Financial Services is a direct banking and payment services company. The Company is a bank holding company and a financial holding company. The Company offer credit cards, student loans, personal loans and deposit products through its Discover Bank subsidiary and home loans through its Discover Home Loans, Inc. subsidiary (Discover Home Loans). The Company operates the Discover Network, its credit card payments network; the PULSE network (PULSE), its automated teller machine (ATM), debit and electronic funds transfer network, and Diners Club International (Diners Club), its global payments network. The Company operates in two segments: Direct Banking and Payment Services. In June 2012, Tree.Com Inc sold the operating assets of its Home Loan Center, Inc. business to a wholly owned subsidiary of Discover Financial Services.

Defensive Investor – must pass all 6 of the following tests: Score = 5/6

1. Adequate Size of Enterprise – market capitalization of at least $2 billion – PASS
2. Earnings Stability – positive earnings per share for at least 10 straight years - PASS
3. Dividend Record – has paid a dividend for at least 10 straight years - FAIL
4. Earnings Growth – earnings per share has increased by at least 1/3 over the last 10 years using 3 year averages at beginning and end of period - PASS
5. Moderate PEmg ratio – PEmg is less than 20 – PASS
6. Moderate Price to Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50 – PASS

Enterprising Investor – must pass all 3 of the following tests or be suitable for a defensive investor: Score = 3/3

1. Earnings Stability – positive earnings per share for at least 5 years – PASS
2. Dividend Record – currently pays a dividend – PASS
3. Earnings growth – EPSmg greater than 5 years ago – PASS

Valuation Summary

Key Data:

Balance Sheet – September 2014

Earnings Per Share

Earnings Per Share – ModernGraham 

Dividend History

Conclusion:

Discover Financial Services qualifies for the Enterprising Investor but not the Defensive Investor.  The Defensive Investor is concerned by the short dividend history while the company passes all of the Enterprising Investor’s requirements.  As a result, Enterprising Investors following the ModernGraham approach based on Benjamin Graham’s methods should feel comfortable proceeding with further research into the company and comparing it to other opportunities.  As for a valuation, the company appears undervalued after growing its EPSmg (normalized earnings) from $1.72 in 2010 to an estimated $4.59 for 2014.  This level of demonstrated growth outpaces the market’s implied estimate of 2.70% earnings growth and leads the ModernGraham valuation model, which is based on Benjamin Graham’s formula, to return an estimate of intrinsic value above the market price.

Be sure to check out previous ModernGraham valuations of Discover Financial Services (DFS) for more perspective!

The next part of the analysis is up to individual investors, and requires discussion of the company’s prospects.  What do you think?  What value would you put on Discover Financial Services (DFS)?  Where do you see the company going in the future?  Is there a company you like better?  Leave a comment on our Facebook page or mention @ModernGraham on Twitter to discuss.

Disclaimer:  The author did not hold a position in Discover Financial Services (DFS) or in any of the other companies listed in this article at the time of publication and had no intention of changing that position within the next 72 hours.  Logo taken from the Wikipedia; this article is not affiliated with the company in any manner.