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Capital One Stock Upgraded: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

A burgeoning trade war with China has devastated global stock markets, subtracting nearly 5% from the value of the S&P 500 over just the past two weeks. But here's something that may surprise you:

For value hunters, this could be good news. All of a sudden, (some) stocks are cheap again.

Take Capital One (NYSE: COF), for example. In late April, after reporting Q1 results, Capital One stock surged 7% on better-than-expected sales and earnings. Investors obviously liked the report, and yet, thanks to broader market turbulence, all of Capital One's gains have evaporated over the last two weeks. At Monday's closing price of $87.54 per share, Capital One actually sold for less than the $87.66 it cost before reporting its Q1 earnings beat.

Five dice labeled buy and sell on top of LCD screen displaying stock charts and numbers

Image source: Getty Images.

Time to upgrade Capital One?

But perhaps not for long. This morning, citing "improving efficiencies" seen in last month's report, and the potential for "bigger payouts" for Capital One shareholders, investment banker Jefferies & Co. announced it is upgrading the stock to buy.

The analyst is also raising its target price on Capital One shares to $115 -- a prediction that, if it proves correct, would yield a nearly 30% profit off of today's prices.

Many reasons to love Capital One

What makes Jefferies so optimistic about Capital One stock? Well, perhaps you saw the recent Wall Street Journal (subscription required) article that described how Capital One rival Citigroup has been emphasizing an online banking strategy over banking at physical bank branches. According to WSJ, the lack of a large installed base of physical branches is helping the megabank to attract depositors and grow in size.

Well, it seems that a similar dynamic is what attracts Jefferies to Capital One. As a largely "cloud-based nat'l/digital bank," the analyst explains in a note covered today on StreetInsider.com (subscription required), Capital One boasts "LT comp. advantages" over rivals tied to a large installed base of physical bank branches. Sure, the megabanks have long offered online banking themselves, and according to the Journal, are ramping up their efforts in this area. However, Jefferies says that Capital One's digital offerings are "meaningfully" ahead of its peers.

"[E]fficiencies/synergies associated with its tech investments," argues the analyst, are leading to "EPS expansion opportunities." At the same time, Capital One's growing profits (the $2.86 per share earned last quarter was up 9% year over year, and up 15% sequentially) offer the potential for "expanding capital distributions to shareholders."

Dividends...and an attractive valuation

Indeed, while Capital One's 1.7% dividend yield is respectable, it's actually below the 2% average dividend yield for S&P 500 stocks. Yet the bank currently pays out only 13% of its profits in the form of shareholder dividends -- leaving a lot of room for the company to grow its payout should it so desire.

At the same time, Capital One shares seem appealing from a valuation perspective. Jefferies calls the stock's 7.4 trailing P/E ratio "attractive," and I cannot disagree.

According to analysts polled by S&P Global Market Intelligence, Capital One is likely to grow its profits at better than 10% annually over the next five years (projections supported in the near term, at least, by its stellar earnings performance in Q1). Relative to that growth rate, the bank's 7.4 P/E ratio looks cheap indeed -- and throw in a 1.7% dividend yield, with the potential for dividend increases, and I'd go so far as to say the stock looks very cheap.

Jefferies is right to recommend Capital One.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.