Earnings

Should You Buy Discover Financial Services (DFS) or Capital One Financial Corporation (COF)?

Discover Financial Services (NYSE:DFS) and Capital One Financial Corporation (NYSE:COF) are the two most active stocks in the Credit Services industry based on today’s trading volumes. Investor interest in the two stocks is clearly very high, but which is the better investment? To answer this question, we will compare the two companies across growth, profitability, risk, and valuation metrics, and also examine their analyst ratings and insider activity trends.

Growth

One of the key things investors look for in a company is the ability to grow earnings at a high compound rate over time. Analysts expect DFS to grow earnings at a 8.70% annual rate over the next 5 years. Comparatively, COF is expected to grow at a 7.00% annual rate. All else equal, DFS’s higher growth rate would imply a greater potential for capital appreciation.

Profitability and Returns



Just, if not more, important than the growth rate is the quality of that growth. Growth can actual be harmful to investors if it comes at the cost of weak profitability and low returns. To adjust for differences in capital structure we’ll use EBITDA margin and Return on Investment (ROI) as measures of profitability and return. Discover Financial Services (DFS) has an EBITDA margin of 76.07%, compared to an EBITDA margin of 51.89% for Capital One Financial Corporation (COF). This suggests that DFS underlying business is more profitable. DFS’s ROI is 11.30% while COF has a ROI of 14.00%. The interpretation is that COF’s business generates a higher return on investment than DFS’s.

Cash Flow 

Cash is king when it comes to investing. DFS’s free cash flow (“FCF”) per share for the trailing twelve months was +2.21. Comparatively, COF’s free cash flow per share was +6.87. On a percent-of-sales basis, DFS’s free cash flow was 7.84% while COF converted 12.08% of its revenues into cash flow. This means that, for a given level of sales, COF is able to generate more free cash flow for investors.




Liquidity and Financial Risk

Liquidity and leverage ratios are important because they reveal the financial health of a company. DFS’s debt-to-equity ratio is 2.47 versus a D/E of 0.95 for COF. DFS is therefore the more solvent of the two companies, and has lower financial risk.

Valuation

DFS trades at a forward P/E of 8.80, a P/B of 2.05, and a P/S of 2.40, compared to a forward P/E of 9.38, a P/B of 0.78, and a P/S of 1.60 for COF. DFS is the cheaper of the two stocks on an earnings basis but is expensive in terms of P/B and P/S ratio. Given that earnings are what matter most to investors, analysts tend to place a greater weight on the P/E.

Analyst Price Targets and Opinions

A cheap stock is not necessarily a value stock. Most of the time, a stock is cheap for good reason. A stock only has value if the current price is substantially below the price at which it should trade in the future. DFS is currently priced at a -20.51% to its one-year price target of $72.95. Comparatively, COF is -16.93% relative to its price target of $95.79. This suggests that DFS is the better investment over the next year.

The average investment recommendation on a scale of 1 to 5 (1 being a strong buy, 3 a hold, and 5 a sell) is 2.00 for DFS and 2.40 for COF, which implies that analysts are more bullish on the outlook for COF.

Risk and Volatility

Beta is a metric that investors frequently use to analyze a stock’s systematic risk. A beta above 1 implies above average market volatility. Conversely, a stock with a beta below 1 is seen as less risky than the overall market. DFS has a beta of 1.44 and COF’s beta is 1.22. COF’s shares are therefore the less volatile of the two stocks.

Insider Activity and Investor Sentiment

The analysis of insider buying and selling trends can be extended to the aggregate level. Short interest, which represents the percentage of a stock’s tradable shares currently being shorted, captures what the market as a whole feels about a stock. DFS has a short ratio of 1.68 compared to a short interest of 2.28 for COF. This implies that the market is currently less bearish on the outlook for DFS.

Summary

Capital One Financial Corporation (NYSE:COF) beats Discover Financial Services (NYSE:DFS) on a total of 7 of the 13 factors compared between the two stocks. COF is growing fastly, has higher cash flow per share, has a higher cash conversion rate and has lower financial risk. In terms of valuation, COF is the cheaper of the two stocks on book value and sales basis, Finally, AXP has better sentiment signals based on short interest.

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