Discover Financial Services
' (
DFS
) stock price plummeted to about $5 during the financial crisis of
2008-09 and has rebounded sharply since then. The current stock
price stands at around $21.70 which is about 10% ahead of
our estimate of $19.76 for Discover's stock
. Two issues we think can move the stock are lower provisions for
losses, which would free up capital to lend and signal Discover's
confidence in its credit exposure, and net interest yields (or net
interest margins) which could be impacted by regulations and the
direction of interest rates. Its main competitors are Capital One (
COF
),
American Express
(
AXP
), Citigroup (
C
), Visa (
V
) and MasterCard (MA).
Discover offers credit cards, personal loans and student loans
as well as deposits. It operates the Discover Network, a credit
card payments network; the PULSE Network ("PULSE"), its automated
teller machine ("ATM"), debit and electronic funds transfer
network, and Diners Club International (Diners Club), its global
payments network.
18% Upside - Decline in Provision for Losses
Provisions for credit losses are charges against income that
banks and credit card companies set aside in case borrowers are
unable to pay. These provisions are based on the composition of the
bank's portfolio, the peceived risk of default, the economic
environment and the allowance for credit losses already
established. For Discover, the provision for loan losses as a
percent of average credit card loan outstanding was under 4% in
2006-7 but increased to over 10% in 2009 due to the economic
downturn and is now turning around.
As the financial sector recovers and economic picture brightens,
we expect a gradual decline in the provision for loan losses as a
percent of average credit card loan outstanding because of the
improvement in the economic outlook and a decline in the net charge
off rate. We estimate that as of 2011, this figure is still above
10% and slowly coming down. Based on our estimates, if it declined
to pre-crisis level of around 6%, our price estimate for Discover
would rise by almost 18%.
10% Downside - Decline in Net Interest Yield
Several government policies have been enforced to reduce or
limit the fees and charges credit card companies and banks can
charge on customers. The CARD Act of 2009, imposed several
restrictions on the company's ability to increase interest rates on
existing balances and to extend credit to customers that have a
high-risk profile. This could have a negative impact on the net
interest yield, or net interest margin. The net interest yield is
the interest income earned by Discover on its credit card balances
outstanding minus all the interest expenses incurred on the credit
card loans.
In addition to regulation the low interest rate environment
makes it difficult to earn a higher net interest yield as Discover
earns less on outstanding balances and the spread between the
borrow and lending rate is narrower.
If the net interest yield declined to about 7% in the coming
years, compared to our estimate of about 9%, our price estimate for
Discover would decline by as much as 10%.
See our full estimates for Discover.