Does Capital One's Discount to Peers Make the Stock a Value Play?

Capital One, the bank holding company that specializes in credit cards, has been grouped among those stocks that seem to have benefited nicely from the pandemic. As a result, its stock price is up about 36% over the last year and while it's not trading at all-time highs, it's still trading at levels much higher than it saw prior to the pandemic.

Given the solid performance of the stock, why could Capital One be considered a value play? Perhaps it's the fact that it has continued to trade at a discount to a lot of its peers in the credit card space -- and at pretty low multiples.

Let's take a look at whether Capital One may be undervalued relative to its peers and whether it's worth consideration as a potential investment.

Image source: Getty Images.

Why is it a discount?

Whether you look at the stock price relative to earnings or to tangible book value (what a company would be worth if it were liquidated), Capital One trades at a discount to its peers. And it's been doing this for a while. Here's a summary of where the valuations currently stand.

Source: YCharts. TTM = Trailing 12 months.

The metrics are a bit closer between Capital One and Discover and Synchrony on a price-to-earnings basis but still very far apart when it comes to price-to-tangible book value. This would suggest the stock is priced cheaply. That raises the question: Is there a good reason for that cheaper valuation?

I think there are a few things to explain the discount over the years. A good metric to use in evaluating banking stocks is the return on equity, which shows the return a company generates on shareholder capital. It's not just important to deliver a strong return on equity but to do so consistently and with as little volatility as possible. As the chart below shows, Capital One has consistently generated a lower return on equity than its peers.

SYF Return on Equity data by YCharts.

Similar but different

Capital One operates in three main segments: It has a credit card business for consumers and small businesses in the U.S. and internationally; it has a consumer banking business, which includes auto lending, depository accounts, and lending products for consumers and small businesses; and it has a commercial banking business. Synchrony's business is based on what it calls a partner-centric model in which it partners with leading retailers and brands in a number of industries to provide financing and credit solutions often at the point of sale. 

Discover offers a variety of consumer lending products, including credit cards, personal loans, student loans, and mortgages, as well as payments capabilities. American Express has created a closed-loop payments system in which it issues its American Express-branded cards to consumers but also handles the merchant-acquiring side of the business in which it helps businesses accept and process transactions from American Express cards.

So while all of these companies are in the credit card space, they are not identical. American Express operates much more like other payment rails such as Visa and Mastercard -- businesses that receive higher multiples. Capital One will likely never trade at these kinds of multiples.

Although its large credit card portfolio separates it from most traditional banks, Capital One's auto and commercial banking businesses pull it more in the direction of a traditional bank than some of its peers. Its overall margins are smaller than Discover and Synchrony's. These smaller margins should ideally give the company an advantage in seeing lower levels of loan losses because of the commercial and auto businesses. But investors may want to wait and see how the company holds up through the upcoming rate cycle, especially with the surge in car prices.

What needs to happen 

Another thing to note in the chart above: Capital One's return on equity jumped way higher in 2021. This change was not uncommon in the industry because many banks released reserve capital previously built up for loan losses expected from the pandemic but which never materialized. Banks also benefited from Paycheck Protection Program loans during the pandemic. Both of those events, however, are winding down and are not recurring, so the earnings power Capital One generated in 2021 is likely not sustainable moving forward.

The good news for Capital One is that loan growth, particularly in the credit card space, has returned. Domestic credit card loan balances grew 10% in the fourth quarter of 2021 from the prior quarter. Management didn't provide much guidance on expected loan growth but did acknowledge that prepayment rates were still high to end 2021. So that could have muted loan growth, although, on the flip side, the strong prepayment rate keeps credit quality very strong. I also think Capital One has a much better capital structure than it had in the past, and the company has been buying back a lot of stock.

Investor takeaway

Going back to my initial question, I do not currently see Capital One as a pure value play and can understand the company's discount to peers. That said, trading at 142% to its tangible book value does make me believe this stock has long-term upside. Capital One needs to manage credit quality effectively through the upcoming rate cycle, capitalize on loan-growth opportunities, and ultimately generate higher risk-adjusted returns on capital.