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DFS operates in the consumer finance sector, which has characteristics that make it unique to other industries. Understanding these differences is crucial when it comes to putting a value on the financial stock. These lenders, for example, must hold certain levels of capital in order to maintain a safe cash cushion. Looking at line items such as book values, in addition to the return and cost of equity, is fitting for gauging DFS’s intrinsic value. Below we’ll take a look at how to value DFS in a reasonably accurate and uncomplicated approach.
View our latest analysis for Discover Financial Services
What Is The Excess Return Model?
Let’s keep in mind two things – regulation and type of assets. United States’s financial regulatory environment is relatively strict. Moreover, consumer financials tend to not hold large amounts of tangible assets as part of total assets. Therefore the Excess Returns model is appropriate for deriving the true value of DFS as opposed to the traditional model, which puts weight on factors such as capital expenditure and depreciation.
Deriving DFS’s True Value
The central belief for this model is, the value of the company is how much money it can generate from its current level of equity capital, in excess of the cost of that capital. The returns in excess of cost of equity is called excess returns:
Excess Return Per Share = (Stable Return On Equity – Cost Of Equity) (Book Value Of Equity Per Share)
= (0.25% – 12%) x $38.72 = $5.23
Excess Return Per Share is used to calculate the terminal value of DFS, which is how much the business is expected to continue to generate over the upcoming years, in perpetuity. This is a common component of discounted cash flow models:
Terminal Value Per Share = Excess Return Per Share / (Cost of Equity – Expected Growth Rate)
= $5.23 / (12% – 2.7%) = $58.98
Combining these components gives us DFS’s intrinsic value per share:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= $38.72 + $58.98 = $97.7
This results in an intrinsic value of $97.7. Relative to today’s price of US$68.40, DFS is currently undervalued. This means there’s an upside to buying DFS today. Valuation is only one part of your investment analysis for whether to buy or sell DFS. Analyzing fundamental factors are equally important when it comes to determining if DFS has a place in your holdings.
Next Steps:
For consumer financials, there are three key aspects you should look at:
- Financial health: Does it have a healthy balance sheet? Take a look at our free bank analysis with six simple checks on things like leverage and risk.
- Future earnings: What does the market think of DFS going forward? Our analyst growth expectation chart helps visualize DFS’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether DFS is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on DFS here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.