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A Rising Share Price Has Us Looking Closely At Discover Financial Services's (NYSE:DFS) P/E Ratio

Simply Wall St

Discover Financial Services (NYSE:DFS) shareholders are no doubt pleased to see that the share price has bounced 45% in the last month alone, although it is still down 45% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 50% in the last year.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). So some would prefer to hold off buying when there is a lot of optimism towards a stock. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

View our latest analysis for Discover Financial Services

Does Discover Financial Services Have A Relatively High Or Low P/E For Its Industry?

We can tell from its P/E ratio of 6.13 that there is some investor optimism about Discover Financial Services. You can see in the image below that the average P/E (4.6) for companies in the consumer finance industry is lower than Discover Financial Services's P/E.

NYSE:DFS Price Estimation Relative to Market May 3rd 2020

Discover Financial Services's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Discover Financial Services's earnings per share fell by 17% in the last twelve months. But EPS is up 6.7% over the last 5 years.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

How Does Discover Financial Services's Debt Impact Its P/E Ratio?

Net debt totals a substantial 126% of Discover Financial Services's market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On Discover Financial Services's P/E Ratio

Discover Financial Services's P/E is 6.1 which is below average (14.4) in the US market. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations. What is very clear is that the market has become less pessimistic about Discover Financial Services over the last month, with the P/E ratio rising from 4.2 back then to 6.1 today. If you like to buy stocks that could be turnaround opportunities, then this one might be a candidate; but if you're more sensitive to price, then you may feel the opportunity has passed.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than Discover Financial Services. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.