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

The world is changing.

Quickly.

Investing in high-quality businesses that are at the forefront of change is a phenomenal way to make money.

Seeing the change occurring right in front of you isn’t difficult.

But knowing which companies to invest in might seem a bit more challenging.

However, it’s actually not much of a challenge at all.

One way to filter out the rest from the best is by looking at high-quality dividend growth stocks.

The Dividend Champions, Contenders, and Challengers list acts as as such a filter.

That list features more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

A lengthy track record of dividend raises is a fantastic litmus test for business durability and quality. 

After all, a company can’t pay a rising cash dividend for years on end without producing the commensurate rising profit for years on end.

It would be like you writing ever-larger checks to your neighbors without making enough money to cover those checks. Doesn’t work.

It shouldn’t be a surprise to know that many of the companies paying out growing cash dividends are at the forefront of change. 

They’re making more money, and paying out more dividends, because they’re selling the products and/or services the world demands. And they’re adapting to any change in that demand.

Fail to adapt, profit dries up and dividends stop flowing.

It’s basic logic.

I’ve used this basic logic to my benefit. And you can use it to your benefit, too.

The strategy of dividend growth investing helped me go from below broke at 27 years old to financially independent and retired at 33, as I lay out in my Early Retirement Blueprint.

I built the FIRE Fund with this strategy.

That’s my real-money early dividend growth stock portfolio.

It generates the five-figure passive dividend income I live off of.

Jason Fieber's Dividend Growth PortfolioOf course, one has to approach dividend growth investing correctly.

Spotting a high-quality company at the forefront of change is one thing.

But buying stock in such a company at an attractive valuation is another.

While price is what you’ll pay for a stock, it’s value that you get for your money.

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

This is relative to what the same stock might otherwise provide 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 correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Buying a high-quality dividend growth stock when it’s undervalued can lead to superior results over the long run.

Combining that with being at the forefront of change could eventually furnish you with life-changing money.

Fortunately, it’s far from an impossible task to find and buy such stocks.

Fellow contributor Dave Van Knapp has made that process easier than ever.

His Lesson 11: Valuation, part of a comprehensive series of “lessons” on dividend growth investing, explicitly describes how to value just about any dividend growth stock out there.

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.

The company operates in two segments: Direct Banking, 96% of FY 2018 EBT; and Payment Services, 4%.

I noted at the beginning of this week’s article how quickly the world is changing.

One of those changes has to do with how people go about paying for goods and services.

The world is rapidly moving toward a cashless society. 

Consumers, businesses, and governments are increasingly using digital payments in lieu of hard cash.

It’s easy to understand why this is happening.

Digital payments are faster, easier, and more secure than paying with cash.

Furthermore, access to credit and cash-back rewards are opportunities that cash cannot compete with.

It’s one of the most obvious and straightforward global megatrends to invest in and profit from.

And since there are already a limited number of worldwide payment processors already in place, which has created a firm oligopoly, it’s easy to place your bets and let the limited competition work to your advantage.

You can go out and buy one of the major players.

But Discover Financial Services might offer the best opportunity of all in this space.

That’s due to two big reasons.

First, they arguably have the longest growth runway in front of them.

That’s because they trail major players like Visa Inc. (V) in terms of transaction volume. The law of large numbers favors a smaller player like Discover Financial Services over the long run, assuming they can grow the network and run the business correctly.

Payment Services makes up only ~4% of the business. However, it’s growing strong. FY 2018 saw transaction volume grow 15% YOY.

Second, there’s the much, much lower valuation.

Most valuation metrics for the Discover Financial Services shares are sitting at a fraction of where things are sitting for the aforementioned Visa stock. I think Visa absolutely deserves a higher multiple for numerous reasons, but the contrast in multiples has become staggering.

Of course, a more accurate valuation comparison would be to a company like American Express Company (AXP), as both businesses have receivables (operating more as banks than pure credit card/payment network businesses).

However, Discover Financial Services features a much lower valuation than even American Express.

This material difference in valuation creates a more favorable dividend picture, too.

Dividend Growth, Growth Rate, Payout Ratio and Yield

The stock offers a market-beating yield of 2.10% right now.

That’s quite a bit higher than what you can get with any of the other credit card companies.

It’s also 20 basis points higher than the stock’s own five-year average yield.

Plus, that comes attached with a 10-year dividend growth rate of 20.1%, which blows American Express out of the water.

There’s plenty more dividend growth to come, too.

The company has increased its dividend for nine consecutive years.

And with a payout ratio of only 19.9%, it’s one of the most well-covered dividends I know of.

Ultimately, however, investors want to know where a business and its dividend are going. We invest in the future, not the past.

Thus, I’ll now build out a forward-looking growth trajectory, which will later help us value the stock.

I’ll first show you what the company 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 estimate of profit growth over the next few years.

Blending the proven past with a future forecast like this should give us plenty of information from which to draw reasonable conclusions about the growth trajectory.

Discover Financial Services grew its revenue from $6.734 billion in FY 2009 to $10.709 billion in FY 2018.

That’s a compound annual growth rate of 5.29%.

A very respectable number here, especially seeing as how American Express has had difficulty with its top line over this same stretch.

Meanwhile, earnings per share advanced from $2.38 to $7.79 over this 10-year period, which is a CAGR of 14.08%.

Now we’re really talking. Impressive stuff.

The excess bottom-line growth was largely driven by one of the most remarkable buyback programs I’ve ever run across.

For context, the outstanding share count is down by ~32% over the last decade, with most of that reduction occurring after FY 2013 (after the US economy had started to solidly recover from the GFC).

And that hasn’t slowed of late. In fact, the company reduced the outstanding share count by another 1.4% during Q3 FY 2019.

Not all buyback programs are great. But the stock has looked attractively valued during much of the period in which the company was aggressively buying back its own stock.

Revenue and Earnings Growth

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

CFRA believes debt saturation, low interest rates, and a very slight increase in the recent net charge-off rate (3.05% for Q3 FY 2019 versus 2.97% in the prior year period) limits the opportunities for revenue growth.

Indeed, low interest rates remain pervasive. And since Discover Financial Services is largely a lending institution, this limits their net interest income and net interest margin.

However, the massive share buyback program and growth runway of the Payment Services segment have to be weighed against these headwinds.

One knock against the Payment Services, though, is the fact that the Discover Network is not as globally built-out as its peers. There’s an acceptance gap that the company will have to work on.

I look at Discover Financial Services as a high-quality bank that essentially has a Payment Services business thrown in for free.

I say that because the Direct Banking segment is by far the larger segment. And it’s a quality business, with competitive metrics across the board, aided by the fact that the company avoids the expensive overhead of branches and markets loans directly.

The company grew its total loans by 7% in FY 2018. They funded those loans, in part, with the help of a 13% increase in deposits.

Yet the valuation of the entire enterprise trails not only its peers in payments but also pretty much every bank I know of.

Furthermore, the Payment Services segment greatly complements the Direct Banking segment, creating a symbiotic and harmonious business model.

Credit card loan receivables are approximately 80% of total receivables, and the company brought on 11% more new card accounts last fiscal year.

More card accounts means more potential net interest income and income from the Discover Network.

In my view, an 8% growth projection could prove to be quite conservative.

Even the most recent quarter reported 15% YOY diluted EPS growth.

But if we take CFRA at their word and model in an 8% CAGR for EPS over the next three years, this still sets up shareholders for low-double digit dividend growth over the foreseeable future.

That’s because the payout ratio is so low. At under 20%, the company can easily afford to grow the dividend at a rate that modestly exceeds that of earnings.

The most recent dividend increase came in at 10%. I would expect dividend growth in that range to persist for now, absent a recession.

Financial Position

Moving over to the balance sheet, the company maintains a solid financial position.

The long-term debt/equity ratio sits at 2.45.

That looks very high at first glance. However, the business structure clouds this. The sizable amount of treasury stock (which actually exceeds shareholders’ equity), cumulatively built up from all of those buybacks, further obscures the picture.

For clarity, Discover Bank’s senior debt is rated by Moody’s, Standard & Poor’s, and Fitch, respectively, as follows: Baa2BBBBBB+. All three rating agencies give Discover Bank’s senior debt a Stable outlook.

We’re looking at investment-grade debt here.

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 24.76% and annual return on equity of 21.94%. Net interest margin came in at 10.27% last fiscal year.

Overall, I think there’s so much to like about this company.

It operates primarily as a high-quality bank that in and of itself is a wonderful business. It’s made to be even more wonderful by the way it markets directly to consumers.

But it also has the advantage of the Payment Services business, which is perfectly positioned to profit from the global move to cashless transactions. Its growth runway is arguably the longest in the industry.

In addition, this business greatly aids the banking side of the company in the sense that most of their loans are actually sourced from balances on credit card accounts.

Of course, there are risks to consider.

Competition, regulation, and litigation are omnipresent risks in every industry.

Regulation is a particular risk for Discover Financial Services, seeing as how it’s largely a bank.

And competition, while limited in the form of an oligopoly of sorts, is fierce.

That competition, especially in terms of aggressive cash-back rewards, may end up causing Discover Financial Services to spend more money in order to acquire and/or keep customers.

Low interest rates remains a primary challenge for all banks.

There’s also the fact that this is a cyclical business model. Any downturn in the economy would directly impact a bank like this.

The largest risk of all could be that of technological obsolescence. If any kind of payments technology comes along that is superior to that of the current payment networks that dominate the world, this would cause severe harm to the business model.

Stock Price Valuation

With these risks known, I still think the stock looks like a fantastic long-term investment opportunity.

The stock’s valuation is lower than most banks, and you’re getting the credit card business basically thrown in for free…

The stock is trading hands for a P/E ratio of 9.45.

That’s very low, even for a bank. And that’s before even factoring in the Payment Services segment. It’s almost like the credit card business doesn’t exist.

This P/E ratio is almost half that of the broader market. It’s also markedly lower than the stock’s own five-year average P/E ratio of 11.6.

Then there’s the multiple on cash flow, currently sitting at 4.9. Compare that to the stock’s three-year average P/CF ratio of 5.6.

And the yield, as noted earlier, is higher than its own recent historical average.

So the stock does look 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 a long-term dividend growth rate of 8%.

That long-term DGR is as high as I allow for.

But I think this stock deserves it. The fundamentals warrant it.

An extremely low payout ratio, a massive buyback program, a clear commitment to big dividend raises, and a near-term forecast for an 8% EPS CAGR all indicate that the company is in a great position to deliver at least this kind of dividend growth for the foreseeable future.

I actually expect something closer to 10% over the next few years, only to see the dividend growth flatten out somewhat when looking out over the longer term.

However, there’s the risk of a recession, which would undoubtedly impact the company’s dividend growth ability. The 8% long-term growth rate includes that short-term risk.

The DDM analysis gives me a fair value of $95.04.

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.

In my view, this is a high-quality dividend growth stock available at a discount.

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 3-star stock, with a fair value estimate of $89.00.

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 $90.00.

I came out slightly high, but we all agree that this stock looks worth more than its price. Averaging out the three numbers gives us a final valuation of $91.35, which would indicate the stock is possibly 10% undervalued.

Bottom line: Discover Financial Services (DFS) is a high-quality company that operates two wonderful and complementary business models. With a market-beating yield, a 20% long-term dividend growth rate, an extremely low payout ratio, and the potential that shares are 10% undervalued, dividend growth investors should take a very good look at this stock right now.

-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 45. 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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