Is Discover Financial 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% 25.4% Pass
  1-Year Revenue Growth > 12% 77.6% Pass
Margins Gross Margin > 35% 100% Pass
  Net Margin > 15% 30% Pass
Balance Sheet Debt to Equity < 50% 277.1% Fail
  Current Ratio > 1.3 1.45 Pass
Opportunities Return on Equity > 15% 19.2% Pass
Valuation Normalized P/E < 20 9.95 Pass
Dividends Current Yield > 2% 1% Fail
  5-Year Dividend Growth > 10% 0%* Fail
       
  Total Score   7 out of 10

Source: Capital IQ, a division of Standard and Poor's. *Growth rate since first dividend in Oct. 2007. Total score = number of passes.

Discover Financial charges up an attractive score of 7. The credit card issuer and network largely hangs in the shadows of its competitors, but it has carved out a reasonable niche over the years.

Twenty-five years ago, Discover Financial was a pioneer in the credit card industry, becoming the first card ever to give cash rewards to cardholders. Now, of course, you'll find rewards-based cards throughout the industry, with plenty of offerings from rivals offering cash and other rewards to customers.

Discover is much smaller than rivals Visa (NYSE: V  ) and MasterCard (NYSE: MA  ) , and the company has a different business model, incorporating both its payments network and its card-issuing unit under one company. As a result, Discover has exposure to bad credit card debt, whereas Visa and MasterCard avoid it by forcing card-issuing banks to assume the responsibility for vetting their credit card customers. That hurt it during the financial crisis, but as the recovery continues and default rates come down, Discover should recover.

Moreover, Discover is already looking forward to a world beyond credit cards. It has partnered up with AT&T (NYSE: T  ) and Verizon (NYSE: VZ  ) to create a mobile-based point-of-sale payment network, which it expects to launch in early 2012.

As a financial stock, Discover has huge amounts of leverage and still doesn't pay a very high dividend. But even though it isn't a perfect stock, Discover does have a lot going for it -- and the future may be even brighter.

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.

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

Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our 13 Steps to Investing Foolishly.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. Discover Financial, AT&T, and Visa are Motley Fool Inside Value recommendations. 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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