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Better Buy: PayPal Holdings vs. Discover Financial Services

By Will Healy - Mar 12, 2020 at 8:30AM

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When deciding which financial services company is a better investment, the numbers may point to some surprising results.

Both PayPal Holdings (PYPL 1.87%) and Discover Financial Services (DFS 3.71%) have prospered in recent years amid a war on cash stocks. As society increasingly turns away from cash transactions, consumers and businesses depend on companies like these to process financial transactions.

Grandview Research predicts that digital payments will reach $132.5 billion by 2025, a compound annual growth rate of 17.6%. At this CAGR, a rising tide may lift all boats. However, the question remains whether PayPal or Discover will see a more significant increase over time. Let's take a closer look and see if the data can help determine which is the better investment.

PayPal pricey, but leads in some areas

Since its spinoff from eBay in 2015, PayPal stock has steadily risen as customers engaging in e-commerce and digital payments increasingly turn to the service.

Part of the company's success revolves around Venmo, a mobile payment service where users can spend and collect money digitally. To help it stand out above Square's Cash App, it acquired Honey Science. This platform allows Venmo users to track both prices and coupons when they become available. Additionally, it improves user engagement, giving consumers a reason to use Venmo daily.

A tablet with graphs with a left hand pointing to the charts with a pen.

Image source: Getty Images.

In December, it also acquired a 70% stake in GoPay, a Chinese mobile payments provider. This made PayPal the first foreign company allowed into China's mobile payments market.

While it still lags the payments platforms run by Alibaba and Tencent, the fact that it has a foothold in the Chinese market puts it ahead of other non-Chinese payment companies. Moreover, PayPal already supports 25 currencies in more than 200 countries.

PYPL Chart

PYPL data by YCharts

However, all of these benefits come at a cost. PayPal has reached a forward P/E ratio of 32.5. While other tech stocks trade at much higher multiples, it is significantly above the S&P 500 average multiple of around 20.75. It also appears to outpace five-year average earnings growth, currently projected at 18.66% per year. As more people and businesses across the world use PayPal, its stock should continue its growth. However, at current levels, it will not come cheap.

Discover offers lower multiple, slower growth

Admittedly, Discover seems to remain an afterthought in the credit card industry. It lags far behind Visa, Mastercard, and even American Express in credit card purchase volume. 

However, it also has built some notable alliances. Discover owns the Diners Club International brand. It also has a partnership with China's UnionPay. While UnionPay is not a household name in the U.S., it is the largest credit card processor in China. UnionPay also accounts for 45% of global credit volume, according to RBR. Those who visit mainland China can use their Discover card anywhere they see the UnionPay logo.

DFS Chart

DFS data by YCharts

Moreover, Discover stock trades at a low multiple, selling for a forward P/E ratio of around 7.1. A mixed profit picture may explain the low multiple. Analysts predict profits to fall by 1.2% this year. However, they expect that to turn around in later years, with the five-year average annual growth rate of 10.15%. Still, this also indicates a mixed picture as analysts look for Visa and Mastercard to report larger earnings increases.

However, investors may see an opportunity. The stock has risen by only about 6% over the last five years. What has helped long-term investors is the dividend. The current dividend of $1.76 per share yields about 3% and has risen for nine consecutive years. Moreover, with its payout ratio at just below 20%, this dividend should remain safe.  

Given this price action, the stock could stage a comeback. The five-year average P/E ratio stands at about 10.9, well above the current multiple. This valuation indicates the stock price could begin to rise as earnings increases return to double-digit levels.

PayPal or Discover?

Given the growth of the digital payments industry, investors will likely win with both stocks. The only question is which one investors should buy first. From a value perspective, the clear choice is Discover.

Yes, Discover lags the other three major credit card companies in market share. However, in a growing industry, paying 7.1 times earnings for 10.15% long-term growth seems too cheap to ignore. Furthermore, investors will receive a dividend that will likely rise every year and one that offers returns well above the S&P 500 average yield of about 1.95%. PayPal does not offer a payout at all.

PayPal will likely see faster growth. It may also outperform Discover relative to its peers. Still, when investors can pay a multiple more than 75% lower and still achieve over half the growth rate, it tilts the value proposition in Discover's favor. 

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Stocks Mentioned

Discover Financial Services Stock Quote
Discover Financial Services
DFS
$107.67 (3.71%) $3.85
PayPal Holdings, Inc. Stock Quote
PayPal Holdings, Inc.
PYPL
$80.12 (1.87%) $1.47

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