While the broader market has enjoyed a strong rally this year, many top financial stocks have continued to struggle. Within that category, Discover Financial Services (DFS 1.62%) has slumped roughly 8% in 2023. Meanwhile, PayPal Holdings (PYPL 2.90%) is down 12% in the same time span.
Which of these underperforming stocks looks like the better buy right now? Read on for a look at both and a determination of which company is the better play for long-term investors.
The pros and cons for PayPal
PayPal stock is now down roughly 80% from the high that it reached in July 2021. For a highly profitable business that's still growing revenue at a solid clip, the company's current valuation looks downright cheap.
PayPal saw total payment volume across its platforms increase 11% year over year to $376.5 billion in the second quarter. Thanks to this tailwind, net revenue increased 7% year over year to reach $7.3 billion, and adjusted net income in the period rose 20% to $1.6 billion.
Crucially, strong growth last quarter wasn't a one-time thing. The company expects to end this year with adjusted earnings per share up 20% on an annual basis.
So why has the stock been performing so poorly?
For starters, the company has now seen its active user accounts decline for two quarters in a row, and investors have broadly grown more cautious about fintech stocks amid rising interest rates. Concerns about a potential recession somewhere on the horizon haven't helped.
Adding another layer of complexity, the company has also seen a management change, with longtime Chief Executive Officer Dan Schulman headed for retirement and being replaced by former Intuit executive Alex Chriss.
If you needed additional cause for uncertainty, the Federal Reserve has also started to roll out its FedNow platform, which allows consumers and institutions to make immediate cash transfers as long as their banks are on board with the service.
There's currently more guesswork involved in charting the company's outlook than long-term shareholders are accustomed to. But the market seems to be weighing the risk factors too heavily.
The big sell-offs have pushed the company's forward price-to-earnings (P/E) ratio down to just 12.8, and the company is valued at just 2.3 times this year's expected sales. Even with some potential challenges on the horizon, PayPal has a huge user base and business model that's proved capable of serving up reliable profits.
The pros and cons for Discover
Discover has continued to serve up strong profits, and the stock actually looks quite cheap in terms of P/E and price-to-sales (P/S) ratios.
Data source: YCharts.
The company's total loan portfolio grew 19% year over year to $117.9 billion in the second quarter, and revenue rose 21% to roughly $3.9 billion. Even with higher operating expenses and a higher provision for credit losses trimming profits 18% year over year, the company's net income of roughly $1.1 billion in the period still looks very strong.
Given the recent business performance, it might initially be surprising to see Discover valued at less than 7 times this year's expected earnings and less than 1.6 times expected sales. So why is the stock trading at such low valuations? A handful of reasons.
In July, Discover disclosed that it had been overcharging merchant customers for 15 years and that it had set aside $365 million for refunds and compensation for those that were affected.
The company also announced that it was the subject of a compliance probe by the Federal Deposit Insurance Corporation (FDIC), the agency that insures customer bank deposits.
The company then announced in mid-August that CEO Roger Hochschild was stepping down and that board member John Owen would become interim CEO.
Besides those sources of uncertainty, there are other risks. With U.S. consumer debt hitting a record high and macroeconomic conditions still looking somewhat shaky, Discover could see credit delinquency rates increase, perhaps significantly.
So while Discover stock looks cheap, there are complicating factors creating downside risk despite its attractive valuation.
So, which stock is the better buy?
Discover's current P/E and P/S multiples have the stock looking cheaply valued, and its share price could see strong gains if delinquency rates don't jump substantially, and the merchant-overcharging and FDIC-compliance issues wind up being smaller problems than some investors anticipate. But the lack of clarity on these fronts makes the stock riskier than its valuation and recent business performance would imply.
Ultimately, I think that PayPal stock looks like the better buy right now. While the fintech is facing some challenges, it remains very profitable, and its valuation has been pushed down to very attractive levels.
Like Discover, PayPal is facing some uncertainty -- but I believe it offers a better risk-reward proposition right now.
