One of the first things an investor should do when evaluating a stock is determine if he or she can understand what the business does and how it makes money. This should be done even before looking at earnings and revenue and all of the other metrics that determine a stockʻs performance. Having a basic grasp of how the company makes money makes it is easier to put all of the performance metrics in context and to develop a deeper understanding of the companyʻs sustainability.
Some companies have very complex business models with money coming in from various sources, all of them generating revenue in different ways. But there are others whose business models are pretty straightforward.
Let's take a closer look at two well-known credit card companies that fall into the latter category -- good, undervalued stocks that are pretty easy to understand.
1. American Express: A favorite of Warren Buffett
American Express (AXP -1.33%) is one of the more iconic brands in the world, known as one of the major credit card companies in operation today. What you may not know is that it is one of Berkshire Hathaway founder and CEO Warren Buffettʻs favorite stocks. American Express has been in the holding company's portfolio since 1993, making it Berkshire's third-oldest holding and its third-largest holding. That commitment speaks for itself.
American Express has a simple and straightforward business model, but it's different from its two larger competitors, Visa and Mastercard. Unlike Visa and Mastercard, which both make money mostly on swipe or transaction fees and doesn't actually loan out funds to cardholders, American Express also serves as a bank that loans out the money that its credit card customers spend. Like a bank, it earns interest on the loan when it is paid back. If the balance is paid off each month, there's typically no interest, but if it's paid off in installments, interest is usually charged.
Beyond interest revenue, American Express also generates income in two other ways -- swipe or transaction fees and annual membership fees. The swipe fees come from the merchant each time the American Express card is used for a transaction. The annual membership fees are basically the dues cardholders pay annually in return for rewards and other perks that come with being a card-carrying member.
The merchant fees, which American Express calls discount revenue, represent about 61% of total revenue. The second-largest source of revenue is interest income, which accounts for about 21% of overall revenue. The annual fees, called net card fees, make up about 12% of the pie. The rest primarily comes from delinquency and foreign currency conversion fees.
American Express stock is a good value, too, with a price-to-earnings (P/E) ratio of 18 and a low P/E-to-growth (PEG) ratio of 0.70, which means the stock's value is low relative to the company's expected future earnings.
2. Discover Financial: Loans drive revenue
Discover Financial (DFS -1.55%) is the fourth-largest credit card company, and like American Express, it differs from Visa and Mastercard. While the business model is similar to American Express', there is a key difference.
Like American Express, Discover is a lender, card issuer, and payment processor, which means that it lends the money for charges made on its credit cards. Basically, it operates a self-contained network. But while American Express makes most of its revenue on merchant fees, Discover makes most of its revenue on interest income. That's because Discover offers revolving credit -- there's no incentive to pay off the balance monthly -- and higher interest rates than American Express. However, it has lower merchant/transaction fees than American Express.
Because it relies on interest income, Discover makes money by having higher loan balances than its competitors, which it seeks to foster with its Cashback Rewards feature, incentivizing customers to use the card more for purchases.
Discover also offers personal and student loans, but the credit card business accounts for the vast majority of its loan business. So Discover basically has two revenue streams -- interest income from its loans, and non-interest income from transactions fees on its network, interchange fees, late payment fees, and others. Interest income accounts for more than 80% of total revenue, with fees income making up the rest. As such, Discover has much more credit risk than American Express.
Discover stock is also undervalued at present, with a P/E ratio of about 7 and a PEG ratio of 0.39. For the PEG ratio, anything under 1 indicates a stock that's undervalued -- and both of these stocks are under 1.
Both are good companies, with simple business models, that are worth considering. While you do your research as to whether these two stocks are good buys or not, you can now hopefully bring to that decision a more complete view of how they make money.