By any reasonable measure, Discover Financial Services (NYSE:DFS) has come back strongly from the worst of the credit crunch - having broken $5 in the spring of 2009, this stock has very nearly reached $35 in the past couple of months. The company has certainly made progress getting more merchants and shoppers to use its cards and network, and it also seems to be picking up a little debit card share in the wake of new regulations. While these shares aren't overpriced, investors may want to ask themselves how much better they think a business can get before they buy shares.

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers

A Noisy, but Basically Good Second Quarter
Discover's second quarter results take a little bit of explanation, but they were basically solid.

Gross revenue rose about 6%, with net revenue (after provisions) up a bit more than 4%. Card loans rose almost 4%, with a 5% increase in card sales volume. Discover is also seeing strong net interest margin (NIM), with NIM improving almost 20 basis points to 9.31%. Loan fee income was weaker, though (down almost 5%) from the previous year.

Discover saw substantially lower net card charge-offs compared to last year (2.79% versus 5.01%), though this number did tick up from 2.64% in the prior quarter. All in all, pretax operating income fell about 6% on a reported basis.

Some analysts are going to adjust this number. During the quarter, Discover took a $90 million additional litigation reserve and that took out about 11 cents of earnings (and adjusted operating income would have otherwise been up 3%). Keep in mind, though, that the company also released about $110 million of reserves (or about 13 cents per share), so I would argue that it largely nets out.

Can Durbin Drive Debit?
Since the Durbin Amendment went into effect, it has had a definite impact on the debit card network business. To make a complex topic simple, new rules have cost Visa (NYSE:V) some of its market share in debit card processing. Now Visa is trying to fight back by exploiting what appear to be loopholes in the new system, but it looks like some of that share in the U.S. is gone for good. MasterCard (NYSE:MA) has picked up most of the benefit, but Discover is getting some of it - dollar volume in payment services was up 12% and pre-tax profits rose 10%.

SEE: Investing In Credit Card Companies

How Much Better Can It Get?
If there's a cogent bear thesis on Discover, it may well center around the notion that this is about as good as business can get - at least in the near-term. Yes, the company is trying to grow its international business and build up other operations outside of its closed-loop card network, but those are all long-term plans.

As seen in this quarter's charge-off data, credit quality is pretty good and may not get substantially better. Likewise, while Discover has seen improved acceptance of its card, further penetration is likely to require heavier lifting (promotional spending, incentives, etc.) that will compress margins. Last and not least, Discover is still a long way from matching American Express (NYSE:AXP) when it comes to building a profitable enterprise from fee-based revenue as opposed to the more volatile spread on receivables.

All of this may well prove true, but it's a question of magnitude and timing. True, there may not be much room for credit quality to improve, but a nice sustained plateau of low charge-offs would certainly be good for the business, the return on equity (ROE) and the stock. Nevertheless, investors should at least consider the risk that this may be as good as the ROE can get.

SEE: How Return On Equity Can Help You Find Profitable Stocks

The Bottom Line
That outlook for ROE is certainly important if you want to value Discover with an excess returns model. While the trailing ROE here is around 30%, most analysts believe this will drop to the mid-to-high teens over the next five years.

If that happens, these shares are probably worth something in the high $30s - not bad relative to today, but not terribly exciting either. Push that long-term estimate up to 20% and the fair value jumps to nearly $50, but then the implied earnings growth rate rises to nearly 10%. That number may be doable, but it's going to take an above-average performance in a very competitive market.

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Professionals

    What to do During a Market Correction

    The market has what? Here's what you should consider rather than panicking.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  9. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
  10. Professionals

    Tips for Helping Clients Though Market Corrections

    When the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!