Shares reacted positively to Discover Financial Services' (NYSE:DFS) fourth-quarter results when the company released its earnings earlier this month. Those earnings gave shareholders hope that the stock's strong run at the end of 2017 was not about to end. In the last three months, the stock has risen almost 25%, after the credit card issuer had finally shaken off loan quality fears that had held down the stock price throughout most of 2017.

There was plenty for investors to like in the company's fourth quarter. Net revenue grew to $2.61 billion, an 11% spike year over year, and diluted earnings per share, once adjusted for nonrecurring charges related to the passage of tax reform, leapt to $1.55, also an 11% year-over-year jump. The top- and bottom-line increase was driven by the growth of its loan portfolio. For the year, Discover's total loans landed at $84.2 billion, a 9% bump year over year. Of course, with this loan growth came a surge in the company's net charge-off rate, the percentage of loans Discover deems unlikely to be paid back. This quarter, the charge-off rate rose to 2.85%, a substantial increase over 2016's fourth-quarter charge-off rate of 2.31%. For the full year, Discover ended with a 2.7% charge-off rate, far higher than in the previous four years.

Metrics Q4 2017 Q4 2016 Change
Revenue $2.614 billion $2.358 billion 11%
Adjusted EPS $1.55 $1.40 11%
Total loans $84.2 billion $77.3 billion 9%
Net charge-off rate 2.85% 2.31% +0.54 percentage points

Data source: Discover Financial Services. EPS = earnings per share.

This is the same problem that has plagued Discover for several quarters now. As loan growth increases, so do loan losses. While that seems inevitable, let's take a closer look at all three facets of Discover's loan portfolio -- credit card, personal, and student loans -- to see what's been driving growth and what's been spooking investors to get a better handle on whether the perceived risks are real or overblown.

Giving credit where credit's due

The star of Discover's loan portfolio is undoubtedly its credit card segment. The company's card loan total at the end of the fourth quarter was $67.3 billion, up 9% year over year. Credit card loans now comprise roughly 80% of Discover's loan portfolio, making it by far its most important loan segment.

Discover Financial logo surrounded by orange.

Discover grew its total loan portfolio to $84.2 billion, a 9% increase year over year. Image source: Discover Financial Services.

During the company's fourth-quarter conference call, as transcribed by S&P Global Market Intelligence, CFO R. Mark Graf said that card loan growth was almost evenly split between existing and new customers, a mix he called "very healthy." By increasing existing customer involvement, Discover is keeping its customers engaged. Discover knows and understands these customers better, theoretically making them safer than new customers for which it has no data. Existing customers also come with cheaper acquisition costs, as they require less marketing expenses.

Hitting the books

Discover's student loan portfolio grew 2% to $9.2 billion and now represents about 11% of its total loan portfolio. While student loans only rose about 2%, its student loan originations climbed by a much faster rate, up 12% from the prior year. Management believes the growth in this loan segment moves Discover up to second place in market share, behind only Sallie Mae in originating private student loans in the U.S. As CEO David Nelms said, "We continue to expand our presence in the student loan market, focusing on early awareness with the website, collegecovered.com, designed to help students and their families prepare for making decisions about college and how to pay for it."

Discover's charge-off rate in this segment is especially low, much lower than the card and personal loan portfolios, coming in at a measly 1.03%. Management says it keeps the charge-off rate so low by focusing on in-school channels. Commenting on these channels, Nelms said, "There's only a few players because you have to do special underwriting, there's cosigners involved, there's disbursements only to schools. So it's operationally pretty unique, and so there's only a few of us that can do that, and we do that very well."

Getting personal

Discover's personal loans are part of the smallest but fastest-growing loan segment in its portfolio. In the fourth quarter, personal loans jumped to $7.4 billion, a 14% increase year over year. Personal loans represent only about 8.8% of Discover's total loans and, ironically, for such a small loan segment, it is also the most troublesome. While management said the segment still generates "strong returns," it is purposefully decelerating its growth due to credit quality issues caused by a shortcoming in its underwriting policies.

Management also stated that this only affected a small subsegment in the space and that it still plans to grow the company's personal loans -- just at a slower pace. As Nelms explained:

And so we think that, in some cases, there's been an oversupply of credit ... where we see the incidence of personal loans and maybe higher debt levels that may impact the people's performance across-the-board. So it is on average a more indebted consumer because sometimes people getting a consolidation loan from a competitor and then maybe not reduce their original balance, so they end up with a higher balance and the same income. And we're not sure that FICO fully picks up this effect because it's a fairly new phenomenon, and FICO scores take a number of years to really even out with -- when there's been a big change in supply or demand of a type of loan product.

The net charge-off rate in this loan segment was considerably higher than the other segments at 3.62% this quarter.

Discovering value

While concerns still exist over the credit quality of its loan portfolio, if the company can fix the underwriting problems experienced in its personal loan portfolio, these worries will probably prove to be unfounded. In 2018, Discover expects its loan portfolio to grow 7% to 9% and its net charge-off rate to fall between 3% to 3.25%. The loan growth would have to hit the high end of the guidance to match this year's growth while the charge-off rate once again dramatically increases.

The company does pay a safe and rising dividend and, given its full-year adjusted EPS of $5.87, trades at a reasonable P/E ratio of just 13.8. Still, given the rising charge-off rates, I would probably look elsewhere for credit issuers worthy of investment, like American Express Company (NYSE:AXP) or Synchrony Financial (NYSE:SYF). American Express consistently maintains the best credit quality in the business and Synchrony might have a better business model for capturing loan growth in the future.

Matthew Cochrane has no position in any of the stocks mentioned. The Motley Fool recommends American Express and Synchrony Financial. The Motley Fool has a disclosure policy.