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

My life has been radically transformed for the better after making one critical decision back in 2010.

That decision was to invest in high-quality dividend growth stocks.

Before that decision, I was completely reliant on a job, an employer, and my ability to continue working until I was old.

All work and no play makes Jason a dull boy.

But after that decision, I became less and less reliant on all of that.

Until one day, I wasn’t reliant at all.

And I quit my job at 32 years old.

I then became financially free at 33, which is when the five-figure and growing passive dividend income my real-life and real-money portfolio of high-quality dividend growth stocks generates on my behalf started to cover all of my basic personal expenses in life.

By consistently investing my savings into great businesses that are generating rising profit and paying their shareholders rising dividends, I was able to build my FIRE Fund.

Jason Fieber's Dividend Growth PortfolioI’ve explored the ins and outs of that journey through my Early Retirement Blueprint, which is a guide that almost anyone can follow to financial independence and early retirement.

You can find more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years by perusing the late, great David Fish’s Dividend Champions, Contenders, and Challengers list.

There are a number of reasons why dividend growth investing is such a fantastic long-term investment strategy, especially if you’re aiming to live off of passive income in a reasonable time frame.

But it boils down to simple logic.

A great business should be growing profit. Otherwise, it’s probably not a great business.

Shareholders are the collective owners of any publicly traded company, and thus shareholders are entitled to their fair share of the growing profit.

That “fair share” is where dividends come in. 

And as profit grows, so should those cash dividend payments.

It’s this growing dividend income that can form an incredibly strong bedrock for anyone’s early retirement.

But as great as this all is, one can’t go and randomly buy up dividend growth stocks.

You should first be doing your due diligence after identifying a potential investment.

That involves looking at financial statements, identifying competitive advantages, and assessing risk.

Perhaps most importantly, you have to value a stock before paying any price.

Without having a good idea of what something is worth, it’s impossible to know whether or not the price you’re paying is appropriate.

Price is what you pay, but value is what you’re getting for your money.

When it comes to buying just about anything in this life, you want a good deal.

But that’s particularly true when buying a dividend growth stock.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

That’s all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield should drive more dividend income both now and over the long term.

In addition, it should drive greater long-term total return potential, because investment income (via dividends or distributions) are one component of total return.

And that potential is given yet another boost via the “upside” that exists between a lower price and higher intrinsic value, as capital gain is the other component of total return.

While the market isn’t necessarily good at accurately pricing stocks over the short term, price and value do tend to more closely correlate with one another over the long haul.

And the possible capital gain, if/when the gap closes, is on top of whatever organic capital gain would manifest itself as a business naturally becomes worth more through the process of increasing its profit.

This all has a way of reducing risk, too.

That’s due to the margin of safety that you build in when you buy a stock at a price that’s well below estimated intrinsic value.

Just in case something goes wrong with the investment, undervaluation provides a buffer that protects your downside, which means you have a defense against ending up “upside down” on your investment (where it’s worth less than you paid).

Undervaluation should be obviously something that every dividend growth investor chases after; however, there’s a process that must be followed in order to ascertain a reasonable estimate of intrinsic value.

Fortunately, fellow contributor Dave Van Knapp has provided one such process, and it’s extremely simple to follow.

That undervaluation process is part of a series of “lessons” he’s written on the dividend growth investing strategy as a whole.

See Lesson 11: Valuation for more on his valuation process.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Discover Financial Services (DFS)

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

There’s a very clear megatrend that’s happening globally: the move to a cashless society.

Purveyors of credit cards (which are part of digital payment networks) and other forms of electronic payments are first in line to benefit from this.

Discover is one such purveyor; however, it’s a bit of a unique company within its space.

That’s because its lending activities, which is more akin to a traditional banking service, is the far larger part of the business.

For perspective on that, the company’s Direct Banking segment accounts for approximately 96% of revenue. The other ~4% of revenue comes from the Payment Services segment.

This is, in my view, actually great news.

That’s because banking is a wonderful business model in and of itself; also, the company’s runway for payments growth is extremely long.

That growth runway is bolstered by both the starting point and the fact that the megatrend practically guarantees significant growth in this area of their business.

To give context, their network volume in Q1 2018 showed a 15% YOY gain in volume.

It gets even better when you consider that the two businesses are highly complementary; more credit card customers should translate into more loan customers (customers who carry a balance on their card).

Based on where the valuation is at (which we’ll get to soon), I look at this as an undervalued banking business with a “free” payment business (that’s growing like crazy) thrown in for good measure.

All of this bodes very well for the company’s ability to pay a growing dividend.

They’ve been making good on that thus far, with eight consecutive years of dividend raises.

That’s nearly as long as that track record could be, considering they were spun off 2007 – right before the financial crisis began.

The five-year dividend growth rate stands at a stout 13.0%.

Discover announced a 14.3% dividend increase just weeks ago, so there’s no slowdown on the dividend growth front.

With a payout ratio of just 25.2%, it seems like this train is just getting rolling.

And that payout ratio is looking at earnings per share.

This company produces prodigious free cash flow, and the dividend sucks up a very insignificant portion of it.

One thing that might detract from this stock’s dividend metrics, though, is the yield.

At 2.27%, there’s probably something to be desired there.

However, that’s more than 60 basis points higher than the stock’s five-year average, relating back to my point made earlier about undervaluation and its effect on yield (and thus total return).

And it’s well above the industry average, especially if you’re looking at other payment processors and credit card companies.

The picture I’m seeing being painted indicates a healthy dividend that’s set to grow at a fairly aggressive rate for the foreseeable future.

Of course, much of that will depend on underlying business growth.

So we’ll look at what Discover has done over the last decade (using that as a proxy for the long haul) in terms of top-line and bottom-line growth, before comparing that to a professional forecast for near-term profit growth.

Combining the known past with the estimated future in this manner should allow us to extrapolate some ideas about where this company is going.

The company increased its revenue from $5.669 billion to $9.897 billion from FY 2008 to FY 2017. That’s a compound annual growth rate of 6.39%.

In my view, that’s an excellent top-line result, especially considering that this period including the greatest economic crisis my generation has ever seen (and probably ever will see).

In fact, revenue barely skipped a beat straight through that stretch, and they came out of the crisis with a major acceleration.

Meanwhile, they grew earnings per share from $1.92 to $5.94 over this 10-year period, which is a CAGR of 13.37%.

I added $0.52 back in to FY 2017 EPS. That reduction due to the tax reform in 2017 is not indicative of the company’s earnings power.

Again, this is quite impressive.

EPS did notably dip during the crisis, but they did an admirable job remaining very profitable. And they gained quite a bit of momentum starting in FY 2011.

Much of the excess bottom-line growth has been driven by share buybacks: the outstanding share count has been reduced by almost 23% over the last decade, and shares continue to be repurchased at an aggressive rate.

Of course, we invest in where a company is going, not where it’s been.

Fortunately, the future looks bright.

CFRA is predicting that Discover will compound its EPS at an annual rate of 8% over the next three years.

While that would be a drop from what’s transpired over the last decade, it would still be a very strong rate of growth.

Plus, due to the low payout ratio, you’d be set up for at least like dividend growth, implying 8%+ annual dividend growth rate for the foreseeable future.

The balance sheet is solid, although it’s blurred a bit due to the business structure and the large amount of treasury stock.

The long-term debt/equity ratio sits at 2.41, which would ordinarily be high if this were a different business or balance sheet.

However, the company’s senior unsecured debt is rated by Moody’s, Standard & Poor’s, and Fitch, respectively, as follows: Ba1, BBB-, BBB+.

Profitability is quite robust, owing to the fact that they take advantage of two separate but complementary businesses that are both wonderful.

Over the last five years, the company has averaged annual net margin of 25.61%.They averaged annual return on equity of 21.50% over that same period.

There’s almost nothing to dislike about this business, in my view.

Of course, you have plenty of competition. There’s regulation and litigation to concern oneself with. And technology can change the landscape of electronic payments over time.

In addition, their banking is a 100% US-based business.

But if the company were just a bank, it’d be quite attractive.

That’s because it essentially operates without the legacy overhead that most other banks operate with, as Discover doesn’t have branches spread out. This reduces their customer acquisition costs rather significantly. And it sets them up well for the future.

This side of the business is exhibiting strong growth, stability, and low overhead.

FY 2017 saw total loans and consumer deposits grow 9%, which is strong.

However, it’s not just a bank.

It also has a very appealing payment network.

With the megatrend that is digital payments, Discover has a tremendous growth runway in front of them, all while actually simultaneously reducing an investor’s exposure to any radical changes that may happen in that space.

At the right valuation, this could be an incredible long-term investment.

Well, the valuation is such that it looks like a cheap bank, with a payment networks business thrown in for free….

The P/E ratio is sitting at 11.09 (adjusting TTM EPS for tax reform).

That’s less than half the broader market.

That’s also quite cheap for just a bank, with pretty much every bank out there sporting a much higher multiple.

Moreover, payment network operators have earnings multiples that are almost three times higher than that.

Revenue and cash flow are both well below their respective recent historical averages.

And the stock’s yield is currently significantly higher than its five-year average, as noted earlier.

So the stock does look cheap here, but how cheap might it be? What would an estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

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

That DGR is on the high end of what I allow for, but I think the business warrants it.

The very low payout ratio, solid business, long-term EPS growth, forecast for future EPS growth, and dividend growth track record all point to this being more or less a base case of what to expect going forward.

Even if the business doesn’t grow nearly as fast as it has over the last decade, it could still grow the dividend in the high single digits for many, many years to come.

But with the company’s small size across both its segments, low overhead, and exposure to a global megatrend, the odds seem pretty good that they’ll pleasantly surprise over the long run.

The DDM analysis gives me a fair value of $86.40.

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.

My perspective and valuation indicates the stock is quite possibly undervalued to a substantial degree.

But let’s compare my number to what two professional stock analysis firms have come up with, which should add depth and insight.

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 rates DFS as a 3-star stock, with a fair value estimate of $77.00.

CFRA 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.

CFRA rates DFS as a 4-star “BUY”, with a 12-month target price of $90.00.

Averaging out the three numbers gives us a final valuation of $84.47, which would mean the stock is potentially 20% undervalued right now.

Bottom line: Discover Financial Services (DFS) is a high-quality company that operates across two fantastic and complementary businesses that are both wonderful, yet the valuation is such that one of those businesses is basically “free” for investors right now. With strong profit growth, an extremely low payout ratio, double-digit dividend growth, and an earnings multiple that’s half of the broader market’s, dividend growth investors should consider depositing this stock in their portfolios.

— Jason Fieber

Note from DTA: How safe is DFS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 65. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, DFS’s dividend appears safe and unlikely to be cut. Learn more about Dividend Safety Scores here.

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