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Better Buy: PayPal Holdings, Inc. vs. Discover

By Matthew Cochrane – Aug 19, 2018 at 9:30AM

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One of these two companies is growing its top and bottom lines at a torrid pace. The other looks to be a rare value stock in today's bull market. But which is a better buy now?

Both PayPal Holdings Inc (PYPL 1.26%) and Discover Financial Services (DFS 2.51%) hold different places in the payments industry. PayPal is a digital wallet platform with a fast-growing and engaged user base. Discover is the smallest of the four major domestic U.S. credit card companies and has a track record of excellent customer service.

This past May, the Census Bureau stated that U.S. e-commerce sales rose to $123.7 billion, a 16.4% increase year over year, in this year's first quarter. During the same period, total retail sales only increased 4.5%. Both companies should be benefiting from this large wind of change sweeping through the world of commerce that encourages the use of digital platforms and credit cards over traditional payment methods such as cash.

However, which of these companies makes for a better investment today? Let's take a closer look at each to see if we can make that determination.

Man shopping on a tablet holding a credit card.

Both Discover and PayPal will benefit from the rise of e-commerce which, by its very nature, encourages using credit cards and digital channels as methods of payment. Image source: Getty Images.

The case for PayPal

In what is becoming a recurring theme, PayPal once again reported a stellar quarter. In the quarter, revenue grew 23% to $3.86 billion, and adjusted earnings per share (EPS) rose 28% to $0.58. Even better than its strong top- and bottom-line growth, perhaps, is its growing active user base. In Q2, PayPal's active user accounts rose to 244 million, a 15% year-over-year increase, and adding 7.7 million new accounts since it reported its first-quarter numbers. Account holders used the platform to make 35.7 transactions per account, a 9% increase year over year, marking an acceleration of growth in user engagement.

In the company's second-quarter conference call, CEO Dan Schulman pointed out that newest users hit the ground running after they join, engaging the platform even more than some of its oldest members, showing the true value of these new members and spelling out an opportunity for PayPal. Schulman said:

Most of the time, you'd expect as you grow your net new actives ... that maybe the quality of those net new actives aren't the same as what they were before. It's actually the opposite here. The ... net new actives are more engaged than our previous cohorts, which by the way means, we have a potential opportunity to educate our older customers on all the new services that we have as well. So, we're feeling pretty good about both net new actives and engagement.

Management credited the increased engagement to several factors, including its popular One Touch platform, new account credit cards, and the fruits of its customer choice initiatives stemming from the many partnerships PayPal has recently initiated.

Of course, an investment with this type of growth doesn't come cheap. With a trailing-twelve-month adjusted earnings per share (EPS) of $2.16, shares currently sport a price-to-earnings (P/E) ratio of over 40. Yet I believe the company's growing network effect -- a service that becomes more valuable as more people use it -- makes the shares worth it. PayPal's user base is growing fast, and these new users are engaging the platform from the moment they sign up -- in many cases more so than long-standing members. That's a neat trick! And that trend shows no signs of slowing down soon.

The case for Discover

In Discover's second quarter, net revenue rose to $2.6 billion, an 8% increase year over year, and diluted EPS grew to $1.91, a 36% increase year over year. Underlining the solid headline numbers was the company's loan growth. Discover's credit card portfolio, about 80% of its total loan portfolio, grew 10% to $67.8 billion.

In addition to the growth, one of the company's nagging problems finally seems to be subsiding. In Q2, loan-loss provisions, funds Discover has set aside for loan losses, increased to $742 million, a 16% increase year over year. While this still easily outpaces loan growth, it actually marks a dramatic reduction from previous quarters. Company management also touted that the net charge-off rate was essentially flat compared to the first quarter's rate, another sign this trend could finally be improving. In the company's conference call, CEO David Nelms attributed this to Discover's disciplined underwriting, an improving economy, and improved analytics the company is using.

Discover's shares trade at a reasonable P/E ratio of 11.1. Furthermore, management certainly is not shy about returning capital to shareholders. In Q2, the company's board authorized an additional $1.85 billion share buyback plan and increased its dividend quarterly payout to $0.40 per share, giving the stock a decent 2.1% yield.

Final verdict

I continue to believe Discover shares represent a decent investment for value investors. Shares trade at a reasonable discount to the market and pay a rising dividend, and while the business model does expose investors to credit risk, I believe that concern might be overblown with the charge-off rate at these levels.

That being said, my pick between these two companies is PayPal. I believe payments will continue to migrate to mobile devices, a trend PayPal seems perfectly positioned to exploit. With a growing and active user base showing no signs of slowing down and strong revenue and earnings growth, this company's shares seem to perfectly fit Buffett's timeless advice to prefer wonderful companies at fair prices over fair companies at wonderful prices.

Matthew Cochrane owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool has a disclosure policy.

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