PayPal Holdings (NASDAQ: PYPL) is a digital wallet, an electronic conduit that enables consumers to make online purchases or direct funds to friends' accounts. Discover Financial Services (NYSE: DFS) is a credit issuer that makes the vast majority of its money by lending to consumers through credit cards, personal loans, and student loans.
While both companies offer financial services to their customers, they fulfill very different roles within the industry. Both companies' stocks also performed very differently in 2018. While PayPal's shares rose almost 24%, Discover's stock price fell about 14%. Has PayPal outgrown a reasonable valuation? Do Discover shares make for a good buy now that they've fallen? Let's take a closer look at each to determine which might make for a better investment today.
An investment thesis could be developed for both Discover Financial and PayPal Holdings, but one definitely seems better positioned for market-beating gains. Image source: Getty Images.
The case for PayPal
PayPal continues to grow its user base, reaching 254 million active accounts when it reported its 2018 third-quarter earnings, representing growth of 9.1 million accounts in the third quarter alone and 34 million new accounts over the trailing 12 months.
This increased user growth underscores PayPal's growing network effect, meaning that as the value of PayPal's services increase for existing users, the more new members want to join. After all, the more consumers that use PayPal, the more merchants will feel compelled to accept PayPal as a method of payment. The more merchants that accept PayPal, the more users will feel compelled to sign on to the platform. And on and on this virtuous cycle goes. That users are finding more value in the platform is evident by the increased engagement its users have with the platform. In the company's third quarter, the average account had used PayPal 36.5 times over the last year, a 9.5% year-over-year increase.
This rapid increase in growth is a testament to PayPal's unique positioning in digital payments. It is the leading digital wallet that is device-, bank-, and merchant-agnostic. Consider Apple Pay. The iPhone maker's platform can be used to pay for items at participating businesses but, to be used for P2P payments, the friend or family member to whom the payment is being paid must also own an Apple mobile device. Zelle, another popular P2P app, can be used only if the user banks at one of the app's sponsors. There are similarly limiting factors for Samsung Pay, Alphabet's Google Pay, and Amazon.com's Amazon Payments.
In the company's third quarter, revenue grew to $3.68 billion, a 14% year-over-year increase, and adjusted earnings per share (EPS) rose to $0.58, a 26% year-over-year jump. With one quarter left to report, PayPal is projecting to finish the year with adjusted EPS in a range of $2.38 to $2.40, which would give it an adjusted P/E ratio of 38.1. While that's certainly a premium valuation, the company's growth prospects and unique competitive positioning make shares of PayPal a compelling addition to investors' portfolios.
The case for Discover
Discover Financial shareholders had a tumultuous year, where even the stock's sharp decline failed to tell the entire story. During the year, the company appointed a new CEO, albeit someone who has been with Discover for 20 years, and constantly had to answer questions about rising loan losses.
In the company's 2018 third quarter, Discover's net principal charge-off, defined as debt it is unlikely to recover, rose to $642 million, a 22% year-over-year increase. In Q3, Discover's net charge-off rate, the percentage of delinquent loans, across its entire loan portfolio was 2.97%. Discover's personal loans segment continues to be the most worrisome, as it experienced a 4.09% net charge-off rate in the third quarter. Beyond seasonality, CFO Mark Graf addressed these concerns in the company's most recent conference call:
[T]he loss experience in certain origination channels we started discussing with you in the third quarter of last year. We cut off all origination activities in these sub-segments as soon as the problems became apparent, but the 24-month seasoning curve in personal loans means that the related losses will peak in the next few quarters. This'll drive dollars of charge-off higher until the pig is through the python.
Despite these problems, the underlying business of Discover continues to perform fairly well. In Q3, Discover's total loan portfolio grew 8% to $86.9 billion. Discover's credit card loans, its largest loan segment, rose 9% to $69.3 billion, good for nearly 80% of Discover's total loan portfolio. Discover's revenue rose to $2.72 billion, an 8% year-over-year increase, while its diluted EPS grew to $2.05, a 29% year-over-year jump. Based on its trailing-12-month EPS of $7.29, the company's P/E ratio is a mere 9.1, representing a significant discount to the market's average multiple.
Discover also sports a shareholder-friendly management team. In Q3, the company repurchased $460 million in shares, reducing its share count by 1.7% in the quarter alone. The company also raised its dividend by 14% in 2018, something it has done consistently since 2011.
The final verdict
Discover Financial's value is compelling. Considering it's growing its top and bottom line, consistently returning capital to shareholders through dividends and buybacks, and trading at a low P/E ratio, I can see Discover beating the broader S&P 500 index. That being said, its credit concerns are just enough to give me pause.
PayPal's valuation, while steep, seems justified given the growing markets of e-commerce and mobile payments in which it operates and what appears to be a sustainable competitive advantage. That's why, forced to choose between these two companies, I would invest in PayPal. It's also why PayPal resides in my personal portfolio.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Matthew Cochrane owns shares of Alphabet (A shares), Amazon, and PayPal Holdings. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, and PayPal Holdings. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.