Is Discover Financial About to Disappoint Investors?

Shares of Discover Financial (NYSE: DFS  ) have been one of the few standout performers in the finance sector over the past six months, rising 49%. They have been riding the coattails of a sizable earnings beat in September and have been boosted higher by data that suggests consumers are spending more per credit card transaction.

I have to admit that Discover was on my buy list for years and almost always appeared as a remarkable value play when compared to MasterCard (NYSE: MA  ) or Visa (NYSE: V  ) . So everything is hunky-dory with Discover right?

Don't count on it.

Priced for perfection
Discover has some very lofty expectations it now needs to live up to after a large uptick in its stock price. A large portion of its third-quarter earnings beat came from a reduction to its loan loss reserves provisioning. I'm not convinced yet that decreasing loan loss reserves are the beginning of a trend.

It remains to be seen if the U.S. consumer can adjust to another wave of mortgage resets -- this time Alt-A mortgages, not subprime -- without having their credit worthiness crumble. Although Discover doesn't operate in the mortgage business, it's very likely it would suffer a spillover effect from any degradation of the housing market.

Legislative logjam
Just the simple fact that Discover engages in both sides of the credit business -- direct lending and transaction processing -- leaves it considerably more vulnerable to economic hiccups. Last quarter, stronger consumer spending boosted Discover's bottom line, but given the relatively flat holiday sales figures we've seen so far, I'm not sure  the immediate future for consumer spending looking rosy.

Congress also recently implemented new legislation that will make it particularly tough for credit card issuers to pass along late fees and overdraft charges to consumers. It's still too early to see by how much this could affect Discover's figures, but logically I'd expect it to have negative implications.

Smoke and mirrors
That leads us to Discover's long-term growth prospects, which paint an even grimmer tale:

Stock

Price-to-earnings (TTM)

PEG Ratio (5-year Expected)

Discover Financial

15.3

3.32

MasterCard

18.8

0.91

Visa

18.5

0.87

American Express (NYSE: AXP  )

14.6

1.2

By these comparisons, Discover might look tempting from a price-to-earnings perspective, but its long-term growth rates are downright anemic compared to American Express, Visa, or MasterCard. A simple look at these price earnings-to-growth ratios show just how deceivingly pricey shares are of Discover.

Discover is set to report fourth-quarter results on Thursday, Dec. 16. Based on this recent run-up, it had better be absolutely exceptional in order to sustain it. There are just too many long-term question marks to justify taking a stab at Discover at these levels. With likely more downside potential than upside, I'm inclined to "Discover the possibilities" from the sidelines.

More financial Foolishness:

Fool contributor Sean Williams does not own shares in any companies mentioned in this article. He tried really hard not to end every sentence with "Discover the possibilities." You can follow him on Motley Fool CAPS under the screen name TMFUltraLong. Discover Financial Services and American Express are Motley Fool Inside Value recommendations. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.

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Related Tickers

10/24/2014 4:00 PM
AXP $86.40 Up +0.79 +0.92%
American Express CAPS Rating: ****
DFS $62.34 Up +0.45 +0.73%
Discover Financial… CAPS Rating: ****
MA $74.00 Down -0.09 -0.12%
MasterCard CAPS Rating: *****
V $213.48 Down -0.80 -0.37%
Visa CAPS Rating: ****

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