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Better Buy: Mastercard vs. Discover

By Billy Duberstein – Feb 19, 2020 at 8:10AM

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Typically viewed as rivals, they couldn’t be more different.

If you're looking to get a credit card, you only have a handful of options within the major card networks. Two such options are Mastercard (MA -0.85%) and Discover Financial Services (DFS -0.55%). Mastercard has the second-largest card network, behind leader Visa (V -1.34%). Meanwhile, Discover has the fourth-largest card network when taking into account its Discover, PULSE, and Diner's Club cards.

Since both companies compete on getting customers and merchants alike to adopt their card solutions, you might think they have similar businesses. But nothing could be further from the truth; a deeper look under the hood reveals two very different companies, with  different growth profiles and valuations.

But which is the better buy today?

Closeup of a woman's hands shuffling through several credit cards.

Mastercard and Discover are very different businesses. Image source: Getty Images.

A payments company versus a bank

The biggest difference between Mastercard and Discover is that Mastercard is essentially a pure-play payment network, while Discover is essentially a bank. Though it does have its own proprietary card network, Discover makes the vast majority of its revenue and earnings from its loan products across credit cards, personal loans, student loans, and home equity loans. In 2019, Discover's payments networks made $3 billion in gross interchange revenue, but only $1.1 billion "net" of the company's generous rewards programs. That's less than 10% of the company's $11.5 billion overall net revenue.

That's a very different business from Mastercard, which is basically just a vast global payments network that makes most of its revenue and profits from transaction fees. In 2019, Mastercard generated a whopping $20.9 billion across domestic, cross-border, and transaction processing fees, in addition to $4.1 billion in "other revenues" comprising cybersecurity, data analytics, and consulting.

In general, the interest income made by banks like Discover is riskier than straight payment processing fees. That's because net interest income is dependent on many things outside of a bank's control, such as the federal funds rate and the overall health of the economy.

Meanwhile, payments networks are much less risky, as there's no underwriting risk. Additionally, the large networks have consolidated down to a handful of large-scale players, easing competition. Finally, all card networks benefit from the long-term trend toward electronic transactions over traditional cash transactions, no matter what the economy is doing. 

2019 operational results

Thus, Mastercard has steadier growth and lower risk, and this shows up in its sterling 2019 performance:

2019 Results

Mastercard

Discover

Revenue growth

13%

7%

Operating income growth

15%

7%

EPS growth

20%

17%

Return on equity

143%

26%

Data source: Mastercard and Discover financial releases. Mastercard numbers non-GAAP, adjusted for one-time litigation expense. Chart by author. EPS = earnings per share.

While Discover's performance isn't too shabby by any means -- 7% growth and a 26% return on equity are high marks for large banks -- Mastercard's operating metrics clearly blow Discover's away. That's especially true of the all-important return on equity, a key metric of business efficiency, which is boosted by Mastercard's massive operating margins over 57%.

But you'll pay up

Yet while Mastercard appears to be the better business, is it a better investment? That's definitely an open question, since these two companies also have massively different valuations.

Valuation Metric

Mastercard

Discover

P/E ratio

42.3

8.3

Forward P/E ratio

31.8

7.8

Price-to-book ratio

58.3

2.0

Dividend yield

0.47%

2.3%

Payout ratio

16.6%

18.5%

Data source: Yahoo! Finance. Table by author. P/E = price to earnings.

As you can see, there's a huge gap between Discover's and Mastercard's valuation metrics. In today's market, investors are bidding up high-quality, recession-resistant growth companies such as Mastercard to extremely high levels. Meanwhile, companies that may have uneven earnings or are more sensitive to economic cycles, such as Discover, have been tossed in the bargain bin.

If you look at the previous table, you'll notice Discover's impressive earnings-per-share growth relative to operating income growth. That's because the company was able to repurchase shares at extremely low prices, decreasing shares outstanding by 7% last year while maintaining a healthy balance sheet.

The huge valuation gap makes the choice more difficult.

What investors should do

The choice between Mastercard and Discover is thus dependent on what kind of investor you are. For long-term-oriented growth investors who like worry-free investments, Mastercard's wide-moat business seems like a safer bet for the long haul, though its lofty valuation might lead to choppy waters here and there.

Nevertheless, value investors who like strong dividends and the security of low valuations may prefer Discover. Discover's metrics aren't as good as Mastercard's -- but they're still pretty darn good for a traditional bank! And while bank valuations have been beaten down by the market due to recession fears, should sentiment change and/or interest rates rise, Discover may eventually rerate higher. 

Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool owns shares of and recommends Mastercard and Visa. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Mastercard Incorporated Stock Quote
Mastercard Incorporated
MA
$284.34 (-0.85%) $-2.43
Discover Financial Services Stock Quote
Discover Financial Services
DFS
$90.92 (-0.55%) $0.50
Visa Inc. Stock Quote
Visa Inc.
V
$177.65 (-1.34%) $-2.41

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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