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Better Buy: Visa Inc. or Discover Financial Services?

By Dan Caplinger - Feb 22, 2016 at 12:02PM

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One of these card network companies has done better than the other lately, but which is more promising now?

Image source: Flickr user Torbakhopper.

The electronic payments industry has been booming across the globe, and that has given Visa (V 0.70%) and Discover Financial Services (DFS -1.77%) opportunities to extend their reach around the world in search of faster growth. Yet the two stocks have moved in different directions over the past 12 months, with Visa posting modest gains in its stock price while Discover has fallen substantially. At their current prices, though, many investors wonder if Discover might be a better buy right now than Visa. Let's compare Visa and Discover Financial Services on a number of metrics to see which makes more sense right now.

Over the past year, Visa and Discover have had dramatically different returns for shareholders. Visa stock has produced a 6% total return for investors, but Discover has fallen 22%.

As you might expect, that has produced a huge disparity in valuations between the two companies. Visa's strength has led the stock market to value its shares at earnings multiples that fit a typical growth stock, and currently, Visa shares trade at 26 times their trailing earnings. By contrast, Discover looks much more like a value stock, carrying an earnings multiple of just 9.

Even when you take expected growth into the equation, the spread between the two stocks doesn't shrink much. Visa trades at a forward earnings multiple of 22, compared to 8 for Discover. Yet in the long run, Visa's valuation could continue to catch up, because Visa investors expect annual growth rates of about 17% over the next five years versus 7% for Discover. Discover is clearly a cheaper stock, but it doesn't have the growth profile that arguably justifies Visa's higher valuation.

For dividend investors, the edge appears to go clearly to Discover. Visa pays a yield of just 0.8%, but Discover's dividend yield triples Visa's at 2.4%.

With such a big difference, you might think that the two companies would have different philosophies about retaining dividends. Yet both Discover and Visa have dividend payout ratios of around 20%, and there's minimal difference between the two. Moreover, both companies have aggressively increased their payouts in recent years. Discover pays 14 times the dividend it did in 2010, and Visa pays more than quadruple the quarterly payout it made six years ago.

If dividends are most important to you, then Discover shows a clear edge. Higher yield and better dividend growth favor it over Visa.

From a fundamental perspective, Visa is much larger than Discover, but both show signs of being able to produce solid growth. Visa recently reported top-line revenue of $3.57 billion, up 5% over the past year even when you take into account the impact of weak foreign currencies on its revenue. Net income of $1.94 billion was up 24%. Visa reported some big wins in obtaining co-branded card partnerships and in pushing into key global markets, and it appears to be on track to continue growing strongly even if the dollar stays strong.

Discover has also found ways to grow. The company said that it had total revenue of $2.09 billion after making provisions for loan losses and interest expense, up 19% from the year-ago quarter. Net income of $500 million grew at a 24% rate compared to 2014's fourth quarter, exactly matching Visa's income growth. CEO David Nelms pointed to record annual originations in student loans and personal loans, emphasizing the value that Discover gets from its retail banking business. In that respect, Discover differs greatly from Visa, as it carries credit risk but also has the potential rewards of cross-selling customers on multiple financial products. Yet both appear to have similar growth prospects going forward.

For those looking to choose between Visa and Discover Financial Services, the main question is whether you're willing to invest in a bank with all the attendant risks involved. Discover has a cheaper valuation, better dividend, and similar growth metrics, so unless you're uncomfortable dealing with the credit risk that Visa avoids in its business model, Discover looks like the better buy right now.

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Stocks Mentioned

Visa Inc. Stock Quote
Visa Inc.
$199.50 (0.70%) $1.38
Discover Financial Services Stock Quote
Discover Financial Services
$95.59 (-1.77%) $-1.72

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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