One way a stock can appreciate is if the market rerates the valuation assigned to the underlying company. For instance, if a company generates $5 per share in earnings and garners an earnings multiple of 10 from the market, it will trade at $50 per share. However, if the business improves and shows it can consistently generate better earnings growth, investors may decide the stock deserves an earnings multiple of 12, boosting the stock price to $60 per share. The key for investors is to try to spot the improvement before the market does. Here are two stocks that can rerate higher due to recent acquisitions.
Capital One's Acquisition of Discover Financial
Recently, the large credit card company, Capital One Financial (COF +2.16%), completed its acquisition of the consumer lender and payments company Discover Financial Services, a huge deal in the financials sector. The big get for Capital One was Discover's closed-end payments system, which is very rare.
The payments landscape is complex, and every credit and debit card transaction involves a network to process it. The largest, most ubiquitous such networks are Visa and Mastercard. These are open payment networks, meaning they allow other companies, like banks, to issue cards to be used on their networks.
Image source: Getty Images.
In open payment networks, the fees are split up among the different participants, but in Discover's closed-loop system, the company issues credit and debit cards and also provides the network, keeping most of the fees for itself.
Up until now, Capital One has issued credit and debit cards on Visa and Mastercard's networks. But after its acquisition of Discover, Capital One plans to move all its debit cards over to Discover's network by 2027, and some of the credit cards as well. Management is modeling $1.3 billion of expense synergies and $1.2 billion from network synergies by 2027.
The challenge is going to be that Discover's network is much less widespread than Visa, Mastercard, and even American Express, so management will need to work on improving the brand and scaling up acceptance of Discover's network internationally.
As you can see below, despite Capital One's solid track record and highly regarded chief executive officer, Richard Fairbank, the stock still trades at a much lower multiple than Visa, Mastercard, or American Express. But payments companies typically receive higher multiples than consumer credit card companies. It would take a lot for Capital One to trade at the same multiple as American Express, which is considered a best-of-breed credit card and payments company; but if Capital One can realize the synergies mentioned above and expand Discover's payments network, the company's earning will grow and the share price likely close some of the valuation gap, rewarding investors nicely.
COF PE Ratio (Forward) data by YCharts
Rocket Companies' Acquisition of Mr. Cooper Group
Although the acquisition is still pending, the mortgage giant Rocket Companies (RKT +0.07%) earlier this year said it planned buy the large mortgage servicer Mr. Cooper Group (COOP +0.00%) in a deal valued at $9.4 billion.
Since going public in 2020, Rocket has not made a good showing, with the shares down close to 50% since then. Being in the mortgage business means being highly dependent on mortgage rates, which are influenced heavily -- although not entirely -- by interest rates set by the Federal Reserve. In 2020 and 2021, historically low interest rates coupled with quantitative easing led to a mortgage boom, as more people wanted to buy homes. Extremely low interest rates also led to a refinancing boom.
However, there are now lots of people sitting on mortgage rates of 3% to 4%, or sometimes even below 3%. For them, buying a new house with a mortgage rate of 6% to 7% would be an unappealing financial decision. Home sales in March dropped to their lowest rate since 2009, and refinancing activity has also decreased significantly since 2021 and 2022.
The acquisition of Mr. Cooper Group provides Rocket with a revenue source that performs better in a rising-interest-rate environment. Mortgage servicing is the business of handling a mortgage, from collecting monthly payments to all the associated administrative tasks. Servicing performs better in a higher-rate environment because fewer people refinance and therefore continuing to make their mortgage payments, which leads to more consistent fees for servicers. Once the acquisition is complete, Rocket expects servicing revenue at the company to increase from 17% of total revenue to 28%.
The acquisition will also help Rocket sop up more share in the fragmented mortgage market. With Mr. Cooper Group, Rocket expects to power one of every six U.S. mortgages and create an end-to-end platform that would ideally be able to help someone purchase their first home, refinance, purchase a bigger home, and cash out equity for a remodeling project.
Rocket's earnings have been erratic since it went public. A more diversified, stabler stream of earnings should lead to higher earnings and a higher valuation over time.
RKT EPS Diluted (TTM) data by YCharts
