Check out financial stocks: solid, but the risk-reward ratio has changed

Introduction

Inflation-prone stocks have fallen in price over the past few months. And loan and credit card companies are part of this group. Discover Financial (NYSE: Homeless) has seen a price drop of more than 20% this year. does the price match the risk-reward? Well, Discover has seen credit metrics increase slightly and the company is now increasing its reserves. But even with this year’s high inflation, Discover is still posting excellent operating results. That being said, I don’t think the company offers the best risk-reward ratio over 1.5x price to book value per share.

This year so far

Performance

Over the past six months, Discover has seen its net investment income increase by 10%. This was largely due to net interest margin growth of 17 basis points, in line with Fed rate hikes. But Discover has started increasing the provision for losses now and has recorded $703 million so far this year, a 405% increase over last year. This is now in normal territory rather than the drawdown of reserves that happened after the pandemic. On a comparable basis, however, this increase in the provision for losses lowered net income by 29% to $2.352 billion. The allocation ratio is now 6.8% and the current economic outlook will likely continue to improve.

Credit Metrics

Review of credit metrics shows a continuing trend of low charges and delinquencies. As can be seen in the chart above, the trend has slowly flattened out, but the numbers are still very low compared to previous years. This shows a healthy consumer facing inflation so far. During the six months, credit card chargeback and chargeback rates decreased 70 basis points and increased 10 basis points to 1.93% and 1.76% each. Private student loans saw increases of 35 and 11 basis points in write-off and delinquency rates, and sit at 0.88% and 1.66%. Private loans fell 113 and 6 basis points to rates of 1.17% and 0.63, respectively. Overall, the trend has slowly changed, but the strong metrics are still evident.

Outlook

Many are concerned about the economic and inflationary outlook for Discover’s business. While these are certainly putting pressure on credit metrics and the ability of customers to repay their loans, it seems to be happening very slowly. As seen above, credit metrics are holding steady low, with small increases each quarter, but nothing to break the bank. And this has already happened in a period of very high inflation. The chart above shows this sharp rise in the inflation rate associated with the Fed rate hikes, but what seems to hold it all together is the fact that people are still working and jobs have yet to been lost in the economic environment. Now, I believe it will eventually happen, unless all the trends stay the same. And when they do, Discover will be hit, but I don’t think it’s going to be a quick event, and the economic environment could change for the better during that time.

Evaluation

As of this writing, Discover is trading around the $92 price level and has seen a price drop of over 20% this year. So is the company a buy at this price level given the risk profile? Well, at this price, Discover is at a forward P/E of 5.94x and a P/BV of 1.88x, which I think is pretty valued. That being said, I would like the P/BV to be closer to 1.5x with the economic risks involved.

Conclusion

Although Discover has performed very well despite the current high inflation, continued inflation in the future will put pressure on the company. I think it may take a while to happen if it does, but this factor changes the risk-reward profile. For this reason, I am not a long while the price is above 1.5x P/BV.