Undervalued Dividend Growth Stock of the Week: Discover Financial Services (DFS)

Imagine telling someone close to you that you’re financially independent.

What would this person think?

They’d probably imagine that you spend your weekends along the Amalfi Coast on your yacht, or maybe you speed around town in your Ferrari.

However, that’s not what financial independence looks like for many people.

I can say that from personal experience – as I retired from my job in the auto industry three years ago, in May 2014, at the tender age of 32.

But I don’t own a yacht… or a Ferrari.

In fact, the owning of expensive and unnecessary things is more likely to be a sign of someone heavily indebted and nowhere near financial independence.

I live a simple life. I live in a small apartment. I mostly eschew restaurants in favor of meals at home. I’ve been a frequent user of my city’s public transportation system for years now.

But I also get to set my own schedule. I get to work on things that I’m passionate about. I can pay core personal expenses – rent, food, mobile phone, etc. – via the passive income I earn, most of which is generated by my personal portfolio of high-quality dividend growth stocks.

My “blueprint” to early retirement is actually easy for just about anyone to follow, even though it doesn’t involve yachts or sports cars.

There’s a lot of saving involved.

And there’s also a lot of intelligent long-term investing involved, which is what today’s article is all about.

Saving a significant chunk of your money is a great start toward early retirement/financial independence, but putting your capital to work is also critical.

And I believe, for a number of reasons, that putting capital to work with high-quality dividend growth stocks is the best way to build both wealth and passive income over the long haul.

Dividend growth investing simply involves buying and holding stock in great businesses that reward their shareholders with growing dividend payments, themselves funded by the growing profit these great businesses are generating.

You can actually find more than 800 examples of dividend growth stocks by checking out David Fish’s Dividend Champions, Contenders, and Challengers list – an incredible resource that contains information on all US-listed stocks that have paid out increasing dividends for at least the last five consecutive years.

While buying and holding high-quality dividend growth stocks sounds easy enough – and in some ways, it is – there’s a bit more to it than that.

Namely, one should make sure they’re buying the right stock at the right price.

What’s the right stock?

Well, that’s up to you.

But it should be a business that you understand. And it should meet your quantitative and qualitative thresholds for quality, including a long-term track record of growing earnings, a solid balance sheet, and great profitability.

What’s the right price?

That’s a bit easier for all of us to agree on.

The right price is actually one that’s as far below fair value as possible.

Said another way, you should aim to buy a high-quality dividend growth stock when it’s undervalued.

Price is simply what you pay. Knowing the price of a stock involves knowing how much it costs.

But price doesn’t tell you what you’re getting for your money.

Value tells you that. Value tells you what a stock is more or less worth. And only by knowing value can you know whether or not the price is appropriate.

A high-quality dividend growth stock that’s undervalued will convey numerous benefits to the long-term investor.

Think a higher yield, greater long-term total return potential, and less risk.

This is all relative to what the same stock would offer if it were fairly valued or overvalued.

For one, price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield directly impacts the amount of income you’re going to receive from your investment.

But the higher yield also positively impacts total return, as the dividends/distributions you receive are one of two components of total return.

The other component is capital gain. And this component is also positively impacted by virtue of the upside that exists between the lower price paid and the higher intrinsic value of an undervalued stock.

While the stock market isn’t necessarily good at pricing stocks correctly over the short term, price and value tend to more or less converge over the long haul.

If/when this happens, that “upside” results in capital gain, which is on top of whatever natural capital gain one experiences as a business becomes worth more and its stock advances in price and value.

Undervaluation can also reduce risk.

That’s because a margin of safety, a buffer, exists when the price paid is well below intrinsic value, as the aforementioned upside exists because downside is simultaneously limited.

If a stock is worth $50, but you pay $40, you have not just $10 worth of upside, but also $10 worth of margin of safety. Just in case the business doesn’t perform as expected, you have a large buffer there before the stock becomes worth less than you paid for it.

Fortunately, estimating the fair value of a dividend growth stock isn’t as daunting as it might first seem.

A great resource for valuation actually exists right here on the site.

Put together by fellow contributor Dave Van Knapp, it’s a lesson on dividend growth stock investing that goes over valuation specifically, and it makes the whole process of valuation fairly straightforward and intuitive.

But I’m not going to leave you readers with just that information.

I’m going to package it all together by going over a high-quality dividend growth stock culled from Mr. Fish’s list that looks to be undervalued right now.

Discover Financial Services (DFS) is a direct banking and payment services company that offers a variety of direct loan products and credit cards.

Discover might be known to most consumers by its namesake credit card.

However, the company actually makes most of its money via its direct lending activities (auto loans, student loans, personal loans, etc.), as its payment network is the smallest in the country.

For perspective, the company’s Direct Banking segment accounts for approximately 96% of revenue, with the remaining 4% coming from the Payment Services segment.

However, it’s important to keep in mind that the vast majority of the Direct Banking revenue comes from the company’s credit card portfolio, so the credit card business is inextricably linked to the lending side. They work in tandem.

In the end, investing in Discover Financial is more akin to investing in a bank than a credit card company.

That said, I like to think of Discover as a high-quality bank with the added bonus that is its payment network – a network that is still scalable and profitable. And it’s the credit cards that provide the lending access.

Plus, Discover has great underwriting standards and a lack of branches, giving it a cost advantage.

These advantages show up when looking at the company’s strong dividend metrics.

Discover Financial has increased its dividend for six consecutive years.

Although a short track record, Discover Financial was spun off in 2007, right as the financial crisis was about to take hold. The timing couldn’t have been worse. So I’m not sure this should be considered a detriment to the company’s overall dividend story.

CaptureIndeed, they have been making up for lost ground: the five-year dividend growth rate is a very impressive 42.1%.

Now, that won’t continue. But the company clearly has the ability to continue increasing its dividend in the high single digits or low double digits for the foreseeable future.

That’s in large part due to an extremely conservative payout ratio, at just 20.5%.

Along with that big historical growth, and outstanding future growth potential, you’re getting a nice yield of 2.01%.

That yield might not be that outstanding relative to what a lot of other dividend growth stocks offer.

But keep in mind that the dividend growth is probably going to exceed what a lot of other higher-yield stocks provide for moving forward.

It’s also notable that the five-year average yield for the stock is just 1.5%, so the stock is currently offering a yield that’s 50 basis points higher than its recent historical average.

In order to formulate a baseline expectation for Discover’s future dividend growth potential, though, we really have to take a look at the underlying growth of the company. And we have to compare that to what the company might do over the next few years.

So we’ll next see what Discover Financial has done in terms of revenue and profit growth over the last decade. That’ll be put up against a near-term forecast for profit growth.

Combined, this should give us an idea as to what kind of overall growth the company is generating, which helps us not only estimate the future dividend growth rate, but also helps us estimate the fair value of the stock.

Discover Financial has increased its revenue from $4.738 billion in fiscal year 2007 to $9.099 billion in FY 2016. That’s a compound annual growth rate of 7.52%.

Meanwhile, the company grew its earnings per share from $1.23 to $5.77 over this same period, which is a CAGR of 18.74%.

This is rather incredible relative to what a lot of banks out there are doing.

The company is prodigious at repurchasing its own shares, which helped propel some of that excess bottom-line growth. In addition, the company has massively expanded its profitability across the board over the last 10 years.

However, share repurchases slowed a bit in 2016. And it’ll be very tough to the company to expand its profitability much more.

S&P Capital IQ believes that Discover Financial will be able to compound its EPS at an annual rate of 9% over the next three years, which would still be more than enough to keep this company very healthy and profitable. One aspect to keep an eye on, though, is its increasing total net charge-off rate.

The rest of the company’s fundamentals are fairly strong, though I think the balance sheet could be cleaned up a bit.

The long-term debt/equity ratio is 2.25, which is in line with its closest major competitor.

S&P rates their senior unsecured debt BBB-. Moody’s rates it Ba1.

Profitability, however, is outstanding, which is where the fundamentals really shine.

Over the last five years, the company has averaged net interest margin of 8.09%, return on assets of 2.93%, and return on equity of 23.22%.

Again, further expansion of these metrics seems unlikely. But they compare very favorably to both the industry and nearest competitors.

All in all, I think Discover offers a lot to like almost across the board.

And increasing interest rates, which are almost a sure thing now, should provide for a long-term tailwind, especially considering Discover Financial’s growing deposit base: consumer deposits were up 13% year-over-year in the most recent quarter.

Yet the stock trades at a very low multiple right now…

The stock’s P/E ratio is just 10.22 right now. That’s lower than not only near competitors, but also banks in general. Moreover, it compares favorably to the stock’s own five-year average P/E ratio of 10.6. So it’s a stock that’s typically been cheap over the last five years, yet it’s even cheaper now. Every other basic metric indicates undervaluation relative to where the stock usually trades. And the current yield, as noted earlier, is well above its own recent historical average.

So the stock does look undervalued here. But what might a good estimate of its intrinsic value be? How undervalued could the stock be?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 8%.

That growth rate is on the higher end of what I allow for; however, the low payout ratio, strong buybacks, huge demonstrated dividend growth over the last five years, excellent underlying EPS growth, and strong forecast for future EPS growth gives me confidence in that.

The DDM analysis gives me a fair value of $64.80.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

So the stock does look to be at least moderately undervalued based on comparable valuation metrics and my own DDM analysis.

But I always like to compare my analysis to that of what professional stock analysts have come up with, as this adds value, weight, and perspective to the conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar ranks DFS as a 3-star stock, with a fair value estimate of $60.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ ranks DFS as a 3-star “HOLD”, with a fair value calculation of $74.20.

Averaging out the three numbers gives us a final valuation of $66.33, which would indicate the stock is potentially 11% undervalued right now.

DFS_chartBottom line: Discover Financial Services (DFS) is a high-quality direct lender that sports excellent profitability. Plus, it has the extra kicker that is its payment network. Yet the stock trades hands at a multiple lower than both banks and credit card companies. The dividend growth potential is outstanding for this conservative lender, and you’re looking at the possibility of 11% upside on top of that. This dividend growth stock flies way under the radar, so it might be time to give it a good look.

– Jason Fieber

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At the end of the day, our hope is that this exclusive training video will make you a better, smarter dividend growth investor.  Grab a cup of coffee, turn up your speakers, and press play on the image above to get started!

 



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