Better Buy: PayPal Holdings, Inc. vs. Discover

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The payments industry is quickly evolving, and while the credit card dynasties aren't going away anytime soon, there is competition from a new breed of payment companies. On one side of the ring is Discover Financial Services (NYSE: DFS), one of the big four credit card companies that have dominated the industry for decades. Representing the wave of the future is PayPal Holdings, Inc. (NASDAQ: PYPL), an online payment processor that allows users to make and accept payments and send money online.

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Each path has its strengths and weaknesses, but for investors looking to invest new money now, which company has better future prospects?

Financial fortitude

Both companies have sufficient levels of cash to meet any near-term obligations. PayPal has no debt, which gives it greater flexibility to respond to any eventuality. Discover also has significant cash, but the number becomes less impressive as it pales in comparison to its total debt obligations.

Company

Cash

Debt

Net Income (TTM)

Free Cash Flow (TTM)

PayPal

$1.24 billion

$0.00

$1.42 billion

$2.49 billion

Discover

$15.16 billion

$26.82 billion

$2.38 billion

$4.10 billion

It is worth noting that while PayPal has no conventional long-term debt, it does book a deferred tax liability, amounting to $1.58 billion. There are differences between what a company can deduct for tax and accounting purposes, usually related to depreciation, and those differences are accounted for on the balance sheet as either a deferred tax asset or liability. In PayPal's case, the accounting deduction has been taken, but the taxes are not yet due and will be paid in coming years. 

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Winner: PayPal.

Recent results and growth prospects

Credit card companies come in a variety of stripes. Some act merely as a conduit, sending money between banks. Others act, not only as the card issuer, but the lender as well. Discover falls into this latter category. The company makes its money from the interest charged on account balances, and it accepts the risk of default for unpaid accounts. Discover is also increasingly betting on student loans for future growth.

In its most recent financial release, Discover's revenue net of interest expense grew to $2.42 billion, up 9% over the prior-year quarter, while diluted earnings per share decreased to $1.40, a 5% year-over-year decline. Total loans increased 8%. The headline in its most recent release, however, was the significant increase in both charge-offs and the delinquency rate. Discover's charge-offs increased 28% year over year to $645 million, and the company increased its provision for loan losses by a whopping 55% over the prior-year quarter. 

Unlike Discover, PayPal takes a cut of each of its payment. It has been rapidly expanding beyond its online payment system roots to become a full-service mobile wallet and digital payment processor. It allows peer-to-peer payments using its Venmo app, which is a hit with millennials. The company's One Touch app allows users to register a device with PayPal and forgo the reentering of login credentials or payment information for that fingerprint- or password-protected phone, tablet, or workstation.

In its most recent quarter, PayPal reported revenue of $3.14 billion, a 18% increase over the prior-year quarter, while net income grew to $411 million, up 27% year over year. The company's active accounts jumped to 210 million, which is up 12% over the prior-year period. Payments per existing customer rose 11% year over year. Payment transactions increased 23% to 1.8 billion over the prior-year quarter.

Discover's recent results pale in comparison with PayPal, which grew revenue at double the rate and continues to gain ground in an emerging trend. Even as Discover moves to limit the damage from charge-offs and additional loss provisions, higher-quality credit will probably further reduce profitability.

Winner: PayPal.

Stock performance and valuation

Over the past year, Discover has failed to keep pace with the broader market, up only 9% to the market's 15% gain. During the same period, PayPal stock has returned an incredible 61%. Given that outstanding performance, the company has been assigned a commensurate higher valuation. From a price-to-earnings perspective, PayPal trades at a lofty 50 times trailing earnings, while Discover trades at a bargain-basement multiple of 10.

Investors are expecting much more of PayPal, as evidenced by its higher multiple. Even looking forward doesn't change that view. PayPal's forward multiple is a slightly lower 32, compared with Discover's unchanged valuation of 10 times forward earnings.

PayPal produced much better stock performance, while Discover represents a much more reasonably priced stock.

Winner: Tie.

Dividends and share buybacks

While PayPal has reduced its share count by 0.16% over the past year, Discover has reduced its shares by a whopping 4% during the same time. If you go back two years, the contrast is even starker: PayPal has reduced its outstanding shares by 1%, compared with Discover's 11% reduction.

PayPal has expanded its stock-repurchase program, adding $5 billion to the $488 million that remained on its previous authorization. Thus far, however, the company has only succeeded in offsetting significant stock-based compensation. Discover has announced plans to repurchase $2.23 billion over the next year.

As PayPal is investing rapidly in its growth, it isn't ready to commit to regular payouts and does not yet pay a dividend. Discover currently pays a dividend that yields 1.9% but has announced plans to increase its dividend by 17%, from $0.30 to $0.35 per share. It currently pays out about 21% of its profits to shareholders, giving the company the ability to continue to increase its payout over time.

Discover gets the nod as the more shareholder-friendly of the two companies, for a serious reduction in its share count and for paying and increasing its dividend.

Winner: Discover.

And the winner is... PayPal

PayPal is the better choice for investors now, by a preponderance of the evidence. It can increase its revenue base and profitability without taking on the additional risk that Discover finds itself saddled with. With one company rooted firmly in the past and the other looking toward the future, PayPal is the winner of this challenge.

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Danny Vena owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool has a disclosure policy.