The financial sector has seen more than its share of challenges recently. Not only has it had to deal with falling interest rates that have taken away some of its ability to earn interest income, but it's also running into potential problems with customers who've suddenly lost their primary means of financial support. For a company like Discover Financial Services (DFS -0.55%) that maintains its own credit card network as well as offering banking services, that combination has been a difficult one to solve.
Discover Financial remains a long-term success story, as the stock emerged from the financial crisis in the late 2000s stronger than ever and delivered strong gains throughout the 2010s. Now, though, investors want to know what the future will hold for the banking and financial company. Here, we'll look at Discover Financial to see if its stock is a buy right now.
Discovering this rising financial powerhouse
Discover Financial has always played second fiddle to larger credit card peers. Hiding under the radar, though, Discover has been an innovator in the industry, including being the first to offer cash back to its cardholders based on a percentage of their spending. Over time, Discover expanded its business to encompass more functions that traditional retail banks served, including making personal loans and offering bank savings accounts and certificates of deposit.
That strategy paid off handsomely in the first half of the 2010s, with consistently rising stock prices. In more recent years, the stock behaved in a choppier manner, in part because of ongoing concerns that the expansion in the U.S. economy would eventually give way to a slowdown or recession. Given the company's exposure to its customers' credit ratings, any rise in delinquencies would potentially have a larger impact on Discover than on many other financial institutions.
Big fears about coronavirus economic impacts
With the coronavirus pandemic, investors in Discover Financial saw their worst fears come true. Many economists now believe that there'll be a deep recession, with some making comparisons to the Great Depression of the 1930s. Tens of millions of people are out of work, and many others who've managed to hold onto their jobs nevertheless have to wait out stay-at-home orders before getting full paychecks again. Those credit-related fears lopped 70% off Discover's share price between late January and March.
Indeed, Discover had to boost its bad loan reserves during the first quarter of 2020, with the more than $1 billion rise in provisions for credit losses forcing the financial company to suffer a modest loss for the period. The company also took steps to reduce expenses as it anticipates further difficulties as long as the outbreak lasts and beyond.
Why Discover looks like a deal
Yet even with Discover's challenges, the financial company is also sensitive to upside surprises. The stock has bounced off its lows, nearly doubling from its worst levels as outlooks for the broader economy grow rosier. In particular, as stay-at-home orders get lifted and businesses get back to work, more of its cardholders will start seeing regular income again. That in turn should help Discover limit its delinquency-related losses, and the rising number of people carrying balances could actually help Discover's bottom line in time.
Moreover, Discover is in better shape than it was back in the late 2000s during the financial crisis. It's been more discriminating in demanding better credit history from its customers than it was in the past, and its capital reserves are healthier than they were a decade ago.
Discover's stock trades at what appears to be rock-bottom valuations based on past earnings, but a lot depends on what you expect the future to bring. Most investors see Discover taking a big bottom-line hit in 2020, but they hope that it'll claw back much of its lost earnings by 2021. Even if Discover can only get half of its lost profits back, a multiple of around eight times forward earnings estimates for 2021 makes the bank stock look like a bargain at current levels -- as long as you believe the economy can recover from the effects of the coronavirus pandemic.