Better Buy: PayPal Holdings Inc vs. Discover Financial Services

By MarketsFool.com

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PayPal Holdings Inc (NASDAQ: PYPL) and Discover Financial Services (NYSE: DFS)are more like industry peers than direct competitors. PayPal garners most of its revenue from transaction processing, while Discover obtains the lion's share of its top line via interest income derived from its credit card receivables. In this edition of our Better Buy series, we'll determine which business structure might yield better stock returns over the long term.

Let's dive in and begin by leveling the field for comparison, so that we can see how each company fares across a handful of pertinent measures:

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Data source: Ycharts. TTM = trailing-12-month.

You'll notice that although PayPal runs a solidly profitable business, Discover enjoys even higher operating and profit margins. Discover's net profit of nearly 26% would be considered extremely healthy in nearly any industry we could name. Discover also turns out a higher rate of operating cash flow per sales dollar.

Yet PayPal is the faster-growing company. Between 2013 and 2015, PayPal expanded its top line at a compounded annual growth rate (CAGR) of 17.25%. Over the same period, Discover achieved a revenue CAGR of 6.1%.

Next, let's look at liquidity, solvency, return on equity, dividends, and relative valuation:

Data sources: Company SEC filings and Ycharts. TTM = trailing-12-month. Current ratio and debt-to-equity ratio calculated as of the most recently reported quarter.Note: Discover debt-to-equity ratio reflects Discover Financial Services parent company debt, and excludes borrowings which Discover uses to fund credit card receivables, direct bank loans, and other interest-generating revenue in its day-to-day operations.

Both companies are extremely liquid, and possess ample funds to meet current liabilities out of assets on hand, as expressed by the current ratio. As for solvency, PayPal has zero long-term debt on its balance sheet. Discover has a manageable debt-to-equity ratio, as long-term obligations equal just one-fifth of stockholders' equity.

While Discover's dividend may be modest given its substantial cash flow generation, it's nonetheless an important total return component for shareholders. PayPal, a growth company, hasn't yet reached the stage where it's ready to issue periodic dividend payments. However, PayPal has started buying back its own shares on the open market, having repurchased $945 million worth of its stock in the first three quarters of 2016. Discover, which regularly buys back its own shares, has returned $1.4 billion worth of stock certificates to its treasury during the same time period.

After wending through all the prior metrics, the last comparison of valuation is perhaps the most surprising. PayPal's valuation is nearly twice that of Discover's on a one-year forward price-to-earnings basis. Investors are willing to pay a differential of 110% to hold PayPal versus Discover, despite the fact that the payments processor trails Discover in many of the essential measures we've reviewed.

This demonstrates the advantage of brisk revenue improvement, prized on both Wall Street and Main Street. Investors often place a premium on well-run companies which can build revenue well beyond the rate of competitors. PayPal continues to expand its total addressable market for transactions by promoting its digital wallet functionality, and seeking to build significant transaction partnerships with the likes of Visaand Mastercard.

Contrast this to Discover, which has built-in constraints on the manner in which it can increase interest income, as summarized recently by CEO David Nelms during the company's most recent earnings conference call:

To translate a bit of industry-speak, Nelms is pointing out that trying too hard to push up consumer and corporate credit card account spending can crimp profits, due to the cost of incentives (i.e., "rewards"). Discover is focused on increasing "prime revolver spend," that is, the monthly credit card purchases of credit-worthy customers, in a more sustainable manner.

This model is responsible for the handsome profits and enviable metrics you see in the tables above. But it doesn't hold the same expansion potential as PayPal's global payments processing.While Discover also participates in a promising transactions business, at present that revenue stream is negligible in relation to the whole. Last quarter, transaction processing of $40 million accounted for a little less than 2% of Discover's total revenue.

For the long-term investor, Discover Financial is a safe, vibrant company poised to reward investors with decent stock appreciation. That it's a bank holding company as well as a financial services holding company, subject to federal regulation, makes its profits all the more impressive.

But PayPal Holdings simply has much more room to enlarge revenue, profits, and ultimately, its stock price, even though it carries a relatively higher earnings multiple. PayPal's vigorous revenue trajectory will create many opportunities for margin expansion in the future, so the company is grabbing market share now and focusing on boosting profits later. Discover may be a great buy, but PayPal is better.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Mastercard, PayPal Holdings, and Visa. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.