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Better Buy: PayPal vs. Discover

John Ballard, The Motley Fool

The payments industry is undergoing dramatic change as more people migrate to a digital economy. But most transactions in the world are still conducted with cash and check and that offers plenty of opportunity for both PayPal Holdings (NASDAQ: PYPL) and Discover Financial Services (NYSE: DFS) to convert those cash transactions over to electronic ones and benefit.

Let's compare PayPal and Discover to determine which is the best investment today.

A woman holding a credit card in her right hand and a smartphone in her left.

Image source: Getty Images.

The case for PayPal

Shares of PayPal have delivered impressive gains of 189% for shareholders since spinning off from eBay in 2015. The company's strategy to partner with leading credit cards and banks to offer users more choice at checkout has paid off in spades. As CEO Dan Schulman put it on the company's fourth-quarter conference call, PayPal wants to be "the de facto operating system for mobile and digital commerce around the world." 

PayPal's recent performance shows it is making good progress in that effort. The company processed nearly 10 billion transactions last year, sending total payment volume up 26% on a currency-neutral basis to $578 billion. Fueling that growth was an increase in two important operating metrics -- new customer accounts, up 31%, and transactions per account, up 9% year over year. 

With PayPal's reputation for delivering consistent growth in revenue and adjusted earnings per share, the stock is not sitting still. PayPal stock is currently flirting with new highs, and it trades at a rich price-to-earnings (P/E) ratio of 37 times this year's earnings estimate. 

The case for Discover

Discover plays second fiddle to the two dominant credit card networks -- Visa and Mastercard. But Discover is in an interesting position in the industry, operating as both a direct digital bank and a payment services company. 

Discover generates most of its revenue from interest income from credit card loans. The company relies on issuing cards to creditworthy consumers who will maintain a balance every month and pay interest. To lure those customers, Discover not only offers very competitive cashback rewards but also provides a range of other financial services, such as student loans, personal loans, and other consumer banking products. 

As a bank, Discover is very profitable, with returns on equity typically around 20%. Last year, the return on equity improved from 19% to 25%. 

The main challenge for the company is to attract new card members. It has lots of competition, considering the dominance and global reach of Mastercard and Visa, as well as American Express. If you have a Discover card, you've probably noticed it's not as widely accepted as Mastercard or Visa. The company is investing to expand globally, and the effort is paying off. The number of acceptance locations increased by 5% last year to reach 44.8 million. 

The stock is up only 34% over the last five years, which is well below the return of the pure-play card processors, Visa and Mastercard. But it is in line with the performance of American Express stock. Discover's relatively low return comes despite the cumulative growth in earnings per share of 59% since 2014. Since the stock price has trailed the actual growth in earnings per share, the P/E multiple is currently a bargain at 8.6 times this year's earnings estimate. 

Which is the better buy?

Over the next five years, analysts expect both Discover and PayPal to grow earnings by 21% per year, which makes PayPal's forward P/E of 37 look extremely expensive compared to Discover's 8.6 forward earnings multiple.

Discover stock doesn't deserve a high P/E because it does carry credit risk with its $90 billion loan portfolio. But as long as the company continues to grow earnings and management continues to run the credit card business with discipline, investors could re-evaluate their expectations by awarding Discover a higher valuation.

For these reasons, Discover is the better buy for investors today.

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John Ballard owns shares of Mastercard and PayPal Holdings. The Motley Fool owns shares of and recommends Mastercard, PayPal Holdings, and Visa. The Motley Fool recommends eBay. The Motley Fool has a disclosure policy.