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Has Discover Financial Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Discover Financial (NYSE: DFS  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Discover Financial.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15% 8.8% Fail
  1-Year Revenue Growth > 12% 44.7% Pass
Margins Gross Margin > 35% 100% Pass
  Net Margin > 15% 37.2% Pass
Balance Sheet Debt to Equity < 50% 212.5% Fail
  Current Ratio > 1.3 1.32 Pass
Opportunities Return on Equity > 15% 30.4% Pass
Valuation Normalized P/E < 20 7.56 Pass
Dividends Current Yield > 2% 1.2% Fail
  5-Year Dividend Growth > 10% 10.8% Pass
       
  Total Score   7 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Discover Financial last year, the company has kept the same seven-point score. The company's return on equity has gone way up as provisions for loan losses have fallen sharply in the past year, reflecting the increasing health in the financial sector.

Discover has always been a niche player in the credit card industry, with its introduction more than two decades ago as a direct challenge to MasterCard (NYSE: MA  ) and Visa (NYSE: V  ) and their dominant card networks. But whereas both Visa and MasterCard sought only to provide the conduit for credit-based transactions, Discover has a payment network and issues its own cards. That boosts Discover's profit opportunities, but it also introduces credit risk that MasterCard and Visa lay off on issuing banks.

But Discover isn't only about credit cards. The company bought Citigroup's (NYSE: C  ) student loan unit last year, and the company also has a banking division that has contributed to its growth and is looking to enter the residential mortgage market in the near future. Moreover, just like fellow network/issuer American Express (NYSE: AXP  ) , Discover is trying to get into the mobile payment business, which could be a key driver of business growth.

Recently, Discover has seen a big upturn in its business. In its most recent quarter, profits jumped 36% and volume rose 7%, even as the company's delinquencies dropped to an all-time low. In particular, Discover has done a good job choosing customers with reasonably high credit quality, which will hopefully keep future payment problems to a minimum.

For Discover to keep improving, it needs to get its debt under control and start aiming to raise its dividend. If the economy keeps recovering, then Discover could easily find itself pushing toward perfection in the years ahead.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Discover Financial isn't the perfect stock, but we've got some ideas you may like better. Let me invite you to learn about three smart long-term stock plays in the Fool's latest special report. It's yours for the taking, and is absolutely free, but don't miss out -- click here and read it today.

Click here to add Discover Financial to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of MasterCard and Citigroup. Motley Fool newsletter services have recommended buying shares of Visa and writing a covered strangle position in American Express. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 30, 2012, at 12:50 PM, CER4040 wrote:

    Unless my eyes deceive me I count 8/10 total score.

  • Report this Comment On April 30, 2012, at 5:01 PM, TMFGalagan wrote:

    @CER4040 - Thanks for your note. The 1.2% dividend yield should be a fail, not a pass, so 7 is correct.

    best,

    dan (TMF Galagan)

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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Related Tickers

7/28/2014 4:04 PM
DFS $62.79 Up +0.18 +0.29%
Discover Financial… CAPS Rating: ****
AXP $91.86 Down -0.07 -0.08%
American Express CAPS Rating: ****
C $49.70 Down -0.33 -0.66%
Citigroup Inc CAPS Rating: ***
MA $76.19 Up +0.44 +0.58%
MasterCard CAPS Rating: *****
V $214.22 Down -0.55 -0.26%
Visa CAPS Rating: ****

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