A Rallying Dividend-Growth Stock With 20% More Upside

This quality company just raised its dividend—and we think its shares have more room to run.

Michael Miller 20 June, 2023 | 4:49AM
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Discover Financial Services DFS stock is up more than 20% since getting dragged down during the regional bank crisis in March. Despite the rally, the shares still look like a bargain to us.

After more than two years of little to no receivables growth and credit losses well below normal levels, Discover was able to generate impressive loan growth in 2022. Although we expect higher net charge-offs in 2023, we don’t foresee this pressuring the balance sheet, as the company is in a strong financial position with good reserves. Additionally, Discover’s net interest income will benefit from a larger credit card receivables base now that growth has returned.

The bank ended December 2022 with more than US$91 billion in credit card loans, 21% higher than the prior year.

Discover generates roughly 70% of net revenue through interest income from its credit cards. While it has substantial private student debt and personal loan portfolios in addition to operating its own payment network, its long-term health will be driven by its ability to build and maintain its portfolio of credit card receivables.

Key Morningstar Metrics for Discover Financial Services

Economic Moat Rating

In our view, Discover has a narrow economic moat around its business that will allow it to continue to earn returns on equity above its cost of capital for the immediate future. The company benefits from the implicit switching costs of its cardholders, its lean cost structure as a direct bank, and some limited cross-selling opportunities available from its multiple product lines. These advantages have allowed returns on equity that have consistently been between 20% and 25%. We expect that as a result of its narrow moat, Discover will continue to enjoy these strong returns for some time.

Read more about Discover’s moat rating.

Fair Value Estimate for Discover Stock

Our US$146 fair value estimate translates to 12.4 times projected 2023 earnings or 2.9 times book value. Discover has benefited from the multiple rounds of fiscal stimulus as a financially strong U.S. consumer has led to credit losses well below normal levels as well as high spending levels on the company’s cards and payment networks. We expect credit costs to increase as net charge-offs rise in 2023 as inflation and a weaker economy pressure consumers. However, Discover is well capitalized with strong reserves, and it is unlikely that higher credit costs will place meaningful stress on its balance sheet, though we project lower earnings this year due to higher provisioning. We project a net interest margin of 8.5% (as we calculate it) once interest rates normalize. We see the company’s efficiency ratio stabilizing at 41.2% by the end of 2027, leading to a long-term return on tangible equity of 22.6%.

Read more about Discover’s fair value estimate.

Risk and Uncertainty

Discover is highly exposed to the credit and interest-rate cycles, so much of its performance depends on macro factors that it has no control over. Credit costs began to rise in the second half of 2022, and consumers are being pressured by inflation. We project materially higher net charge-offs this year and next as economic pressure and higher borrowing rates lead to more delinquencies. However, Discover’s strong financial position, with a common equity Tier 1 capital ratio of 13.3% at the end of December 2022, should allow it to withstand higher credit losses, and we do not foresee the bank coming under severe financial pressure in the near term.

Read more about Discover’s risk and uncertainty.


Discover Bulls Say

  • The company has consistently generated returns on equity that are among the highest of its peers.
  • Discover’s credit card receivables growth has been above the industry average for some time now. This outperformance continued in even in 2020, when its receivables balance shrank less than its peers’.
  • Discover has made good progress in improving its deposit base through online savings accounts and more recently online checking.

Discover Bears Say

  • Discover is subject to the same competitive rewards environment as other credit card issuers. Its rewards rate has climbed over time and is likely to continue to do so.
  • The company has a higher cost of funding than some of its peers, giving it a disadvantage when funding a portfolio of receivables.
  • Discover’s credit costs are rising as credit card net charge-offs increase in the face of deteriorating economic conditions.


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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Discover Financial Services125.71 USD3.04Rating

About Author

Michael Miller  is an equity analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

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