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

The stock market has been particularly volatile over the course of December.

This is a wake-up call to those that haven’t been investing that long.

If you’re buying low-quality stocks or unprofitable companies, this volatility could be just the beginning of a longer-term reckoning.

However, if you’re buying high-quality businesses at reasonable valuations, you’re probably welcoming this short-term volatility as a long-term opportunity.

One of Warren Buffett’s best quotes seems apt right now.

“Only when the tide goes out do you discover who’s been swimming naked.”

A rising tide lifts all boats.

A market that’s relentlessly rising can temporarily cover naked swimmers. 

But when it’s all said and done, quality matters.

So make sure you’re investing intelligently for the long run so that you don’t end up swimming naked.

When I think of “intelligent investing”, the strategy that immediately comes to mind is dividend growth investing.

This strategy, almost by its very nature, tends to limit you to investing in only some of the best businesses in the world.

That’s because you’re buying stocks with lengthy track records of paying and increasing cash dividend payments to shareholders.

By extension, you’re almost always looking at lengthy track records of increasing profit.

It’s very difficult to have the former without the latter.

To see what I mean, check out the Dividend Champions, Contenders, and Challengers list.

That list contains invaluable information on more than 800 stocks that have raised dividends each year for at least the last five consecutive years.

Numerous blue-chip stocks are on that list.

Shouldn’t be a surprise. It’s nigh impossible to run a low-quality business while simultaneously paying out generous and growing dividends for years on end.

As such, it’s nigh impossible to be a dividend growth investor and end up swimming naked.

Indeed, I feel pretty good about my own lack of nakedness as the tide recedes.

Jason Fieber's Dividend Growth PortfolioMy personal stock portfolio, which I call my FIRE Fund, is chock-full of high-quality dividend growth stocks.

And it generates the five-figure and growing passive dividend income I need to live off of, rendering me financially independent in my 30s.

The stock market has recently been volatile. But I can tell you what hasn’t recently been volatile.

Dividends. 

Stock prices go up and down every day. But dividends do not.

This is just one reason I used the dividend growth investing strategy as the backbone of my journey to financial freedom in my early 30s.

Make sure to read my Early Retirement Blueprint for more on how that journey played out!

Buying high-quality dividend growth stocks when they were undervalued was imperative throughout that journey.

Price is only what you pay, but value is what you actually get.

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

This higher yield should directly lead to greater long-term total return potential.

Total return is investment income and capital gain.

A higher yield should obviously mean more investment income.

Capital gain is also given a possible boost, though.

That’s via the “upside” that exists between a lower price paid and higher intrinsic value of a stock.

The stock market might not be great at accurately pricing stocks in the short term. But price and value do tend to more closely correlate over the long run.

Buying a stock when there’s a favorable disconnect between price and value should lead to that upside, in time.

It should also allow for a margin of safety.

That reduces risk.

Because we can’t foresee the future, we should always seek a “buffer” that protects our downside as much as it maximizes our upside.

It’s clear to see how these dynamics are advantageous.

Fortunately, it’s not that difficult to spot undervalued dividend growth stocks.

In fact, fellow contributor Dave Van Knapp has made it even easier through his free valuation template that’s part of a series of educational articles on dividend growth investing.

Access that template in Lesson 11: Valuation.

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.

One of the most obvious megatrends in existence is the move toward a cashless society.

It’s painfully clear that cash will be less circulated/used in the future.

Best of all, it’s one of the easiest megatrends to profit from. Making cash from the move away from cash is ingenious.

I say it’s easy because there are only a few major global credit card networks in existence. This has created an oligopoly of sorts.

All of them offer almost unlimited low-cost scalability on the back of massive network effects. And because most of the world still uses cash, the runway for growth is extremely long.

Perhaps the most potential for this lies with Discover specifically.

That’s because payments makes up a very small portion of the company’s revenue and profit.

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.

Discover is mostly a lending institution. That’s great because banking is in and of itself a wonderful business model.

Not only that, but Discover offers its products and services directly to the consumer, bypassing the overhead that legacy banks have to deal with.

Furthermore, the two segments are complementary and existentially linked to one another.

More credit card accounts being opened means more potential lending customers. That creates business both on the network and lending side.

The megatrend is really just getting started. Discover is positioned almost perfectly because it already has a high-value network established with arguably the longest runway of all the major electronic payments companies.

This bodes well for the company’s ability to pay a growing dividend.

Discover has increased its dividend for eight consecutive years.

None of the electronic payments companies have extremely lengthy dividend growth track records. However, we invest in where a company is going, not where it’s been.

What Discover might lack in terms of length, they make up for in terms of growth.

The five-year dividend growth rate is an impressive 26.6%.

And with a payout ratio of 22.0%, there’s room for plenty more where that came from.

On top of that massive growth comes a very respectable yield of 2.75%.

That yield, by the way, is more than 110 basis points higher than the stock’s own five-year average. It’s also well above the industry average, as well as the market.

The dividend metrics are fantastic across the board.

One key risk, however, might be where we’re at in the economic cycle. It’s worth noting that Discover did cut the dividend during the Great Recession, although the company remained profitable straight through that economic catastrophe.

An important aspect of valuing a business is estimating future growth.

Again, we invest in where a company is going, not where it’s been. But looking at the long-term proven growth certainly gives us something to build on.

So we’ll take a look at what Discover has done over the last decade in terms of top-line and bottom-line growth. Then I’ll compare that to a near-term professional forecast for profit growth.

Taken together, this data should tell us a lot about where Discover might be going.

Discover grew its revenue from $5.669 billion in FY 2008 to $9.897 billion in FY 2017. That’s a compound annual growth rate of 6.39%.

This would ordinarily be a strong rate of revenue growth for any large company.

But I think it’s especially impressive for Discover when considering the beginning of this period included a massive financial meltdown.

As aforementioned, they remained profitable throughout this period.

In fact, they’ve been incredibly profitable.

Earnings per share advanced from $1.92 to $5.94 over this 10-year stretch, which is a CAGR of 13.37%.

Spectacular, really.

I added $0.52 back to FY 2017 EPS to account for a one-time tax charge that doesn’t materially affect the company’s long-term earnings power.

We can see that there’s a lot of excess bottom-line growth.

Discover bought back a substantial amount of stock over the last decade, and they continue to do that. This is taking very solid top-line growth and supercharging it through a reduction in the outstanding share count.

The outstanding share count is down by almost 23% over the last decade, for reference. And they repurchased $460 million in stock during Q3 2018 alone (against a market cap of under $19 billion).

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

Loan growth, buybacks, and higher net interest margin aided by rising interest rates are all catalysts. But these are offset by rising reward expenses in a competitive credit card space, along with increasing net charge-off rates.

An 8% CAGR for EPS, if it were to come to pass, would be more than acceptable, in my opinion.

That would be a slowdown relative to the last decade. But the recovery period post-crisis has been one of the biggest economic expansions we’ve ever seen.

However, even just 8% EPS growth (or something even a bit lower) would still allow for double-digit dividend growth for the foreseeable future by virtue of where the payout ratio is at.

Outside of a complete economic collapse near, or on par with, the Great Recession’s level, Discover is positioned very well to execute, grow, and pay increasing dividends for years to come.

Discover maintains a good (but not excellent) balance sheet.

The long-term debt/equity ratio sits at 2.42.

That looks very high at first glance. But the business structure clouds this. The sizable amount of treasury stock further muddies things.

For clarity, Discover Bank’s senior debt is rated by Moody’s, Standard & Poor’s, and Fitch, respectively, as follows: Baa2, BBB, BBB+.

So it’s investment grade stuff across the board. Not high grade. But it’s not anywhere near junk.

The company’s profitability is extremely robust. Not surprising since they’ve combined two complementary businesses that are each independently highly profitable.

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.

Of course, there are risks to consider here.

Banking is extremely competitive. And the electronic payments space is just as competitive. Discover operates across both.

In addition, regulation and litigation are omnipresent issues.

Plus, technology could change the landscape of both banking and electronic payments.

But there’s really so much to like about this business.

If it were just a bank, Discover would be a fine investment.

FY 2017 saw total loans and consumer deposits grow 9%. Excellent.

Strong growth. That’s all domestic. The bank is 100% US business. High-grade and highly-paid clientele.

Customer acquisition costs and overhead are very low because they don’t have a bunch of expensive branches to contend with.

But Discover is not just a bank.

It also has a very appealing electronic payments network.

This megatrend is playing out. And Discover continues to extend its global reach. This increases its scale capabilities and the impact of the network effects.

Plus, more credit card customers translates to more possible banking customers. And vice versa.

Yet the low valuation basically throws that electronic payments business in for free…

The stock is trading hands for a P/E ratio of 7.90.

I added back in that aforementioned $0.52 to TTM EPS.

That multiple is well below where banks are trading at, let alone electronic payments companies.

It’s actually well below the stock’s own five-year average P/E ratio of 11.3. I don’t think I even have to say how much lower it is than the broader market!

Moreover, the P/CF ratio of 3.3 is almost half the stock’s own three-year average P/CF ratio of 6.2.

After dropping almost 30% from a 52-week high reached just three months ago, the stock appears to be unbelievably cheap. But how cheap might it be? What would a reasonable 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 upper end of what I normally allow for.

I believe this company qualifies, though.

The historical dividend growth thus far has been phenomenal. The payout ratio is so low, the company could stop growing and still deliver double-digit dividend growth for years to come. And the growth runway is clear.

However, the age of the economic cycle could portend a slowdown for Discover (and all banks).

And less global commerce might cause a drop in transactions across electronic payments networks.

Short-term bumps are possible. I think the long-term looks exceedingly bright.

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

The stock’s price of almost $82 back in September might not have allowed for a margin of safety.

Now I believe the stock is now clearly on sale.

At less than $59, my valuation shows a compelling long-term opportunity.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our 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 rates DFS as a 4-star stock, with a fair value estimate of $78.00.

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 3-star “HOLD”, with a 12-month target price of $75.00.

I came out a little bit high. But nothing too askew. Averaging out the three numbers gives us a final valuation of $79.80. That would indicate the stock is potentially 37% undervalued right now.

Bottom line: Discover Financial Services (DFS) is a high-quality company that operates two wonderful business models in a cohesive and complementary manner. One of those businesses is part of an oligopoly. Fantastic growth, robust profitability, an extremely low payout ratio, double-digit dividend growth, a yield way above the industry average, and the possibility that shares are 37% undervalued means this is one of the more captivating long-term dividend growth investments available.

-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 54. 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 borderline safe with a low risk of being cut. Learn more about Dividend Safety Scores here.

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