Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Discover Financial (NYS: DFS) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Discover Financial.
What We Want to See
Pass or Fail?
5-Year Annual Revenue Growth > 15%
1-Year Revenue Growth > 12%
Gross Margin > 35%
Net Margin > 15%
Debt to Equity < 50%
Current Ratio > 1.3
Return on Equity > 15%
Normalized P/E < 20
Current Yield > 2%
5-Year Dividend Growth > 10%
7 out of 10
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Discover Financial last year, the company has kept the same seven-point score. The company's return on equity has gone way up as provisions for loan losses have fallen sharply in the past year, reflecting the increasing health in the financial sector.
Discover has always been a niche player in the credit card industry, with its introduction more than two decades ago as a direct challenge to MasterCard (NYS: MA) and Visa (NYS: V) and their dominant card networks. But whereas both Visa and MasterCard sought only to provide the conduit for credit-based transactions, Discover has a payment network and issues its own cards. That boosts Discover's profit opportunities, but it also introduces credit risk that MasterCard and Visa lay off on issuing banks.
But Discover isn't only about credit cards. The company bought Citigroup's (NYS: C) student loan unit last year, and the company also has a banking division that has contributed to its growth and is looking to enter the residential mortgage market in the near future. Moreover, just like fellow network/issuer American Express (NYS: AXP) , Discover is trying to get into the mobile payment business, which could be a key driver of business growth.
Recently, Discover has seen a big upturn in its business. In its most recent quarter, profits jumped 36% and volume rose 7%, even as the company's delinquencies dropped to an all-time low. In particular, Discover has done a good job choosing customers with reasonably high credit quality, which will hopefully keep future payment problems to a minimum.
For Discover to keep improving, it needs to get its debt under control and start aiming to raise its dividend. If the economy keeps recovering, then Discover could easily find itself pushing toward perfection in the years ahead.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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At the time thisarticle was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of MasterCard and Citigroup. Motley Fool newsletter services have recommended buying shares of Visa and writing a covered strangle position in American Express. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.
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