1 Stock to Buy if Inflation Goes Up

Over the last year, rising inflation has sent investors scrambling to find higher returns in the stock market. At the end of 2021, year-on-year inflation was running at 7 percent, and the rate is expected to remain higher than usual throughout 2022.

 

While high inflation is never good for investor returns, some stocks are better equipped to ride it out than others. One stock that seems to be in an excellent position as inflation and interest rates rise is Discover Financial Services (NYSE:DFS). Here’s why this benchmark credit card company may be a good stock to buy if inflation continues to rise.

Before jumping into the argument for owning discover, it’s important to understand one crucial difference between the company and other credit card issuers.

 

Unlike its competitors, Discover is both a payment processor and a digital bank. This allows Discover to earn money both from processing fees and interest on loans.

 

Discover stands out as a good stock for periods of higher inflation for two key reasons. To begin with, the company’s position as a digital bank allows it to profit from rising interest rates. Some projections show the Federal Reserve increasing baseline rates by up to 150 basis points this year to tamp down inflation. Rising interest rates generally support higher banking profits.

Discover has also returned an average of 15 percent annually over the last 10 years. In 2021, the stock returned a remarkable 28 percent. This growth history suggests that the company can likely outpace all but the worst inflation by a substantial margin. 

 

It’s also worth noting that Discover is insulated from some of the risks assumed by other banking companies. Because it is purely digital, Discover doesn’t have the overhead costs associated with maintaining and staffing physical branches. These costs will likely rise as inflation continues to increase, giving digital banks like Discover a strong operational advantage over their more traditional counterparts.

 

Together, these factors paint a very positive outlook for Discover. As interest rates rise, the company can take advantage of its digital banking presence and highly developed efficiency to gradually increase its revenues, earnings and profits.

 

Since the company has managed to offer excellent returns even in a lower rate environment, it should be able to maintain its streak as rates rise. As a result, investors who hold Discover shares will likely have a decent buffer against inflation and a way to profit from the Fed’s response to it.

 

There’s much more to Discover than just a decent stock to hold as inflation and interest rates rise.

 

According to its Q4 reporting, Discover increased its total loans by 4 percent year-on-year in the final quarter of 2021. The company’s key digital banking segment showed extremely strong growth, with pretax income increasing by $467 million over the previous year for a total of $1.5 billion. Net interest income also increased by $106 million, a gain of 4 percent.

 

Earnings also saw very strong growth in 2021. For Q4, Discover reported diluted EPS of $3.64 per share, up from $2.59 the year before. This amounts to a 41 percent year-on-year growth in earnings.

 

Market share trends also seem to favor Discover in the credit card industry. Last year, the company increased its share of the total market by 2 percent against Visa and Mastercard.

While this is certainly a small gain, it shows that Discover is continuing to gain ground on its two closest competitors. More importantly, delinquencies were also lower in 2021. This suggests that Discover is growing its market share while maintaining a base of high-quality creditors.

 

The stock is also priced at a modest trailing P/E ratio of 6.45. While this is roughly in line with the rest of the consumer financial services sector, Discover’s historically high growth rates and future potential make it an attractive buy at this low multiple. This is especially true in today’s market, where many growth companies trade at very high prices that may or may not be justified by their future earnings prospects.

 

Finally, Discover supports its total return to investors by paying a modest dividend. With a yield of 1.72 percent, Discover’s dividend isn’t massive. It is, however, enough to be a serious contributing factor in total return.

 

Dividends are an excellent offset for inflation since they make it possible for investors to generate some cash flow from their assets. With a combination of high growth and a decent yield, Discover shares give investors coverage against inflation in multiple ways.

 

Analyst price forecasts suggest that Discover could have another extremely strong year in 2022. The median target price from 18 analyses stands at $144, compared to the current price of $110.20.

 

This median gives Discover stock an upside of just over 30 percent. Even the low estimate of $127 would give the stock a 15 percent upside, allowing it to hold its return in line with the average of the last 10 years.

 

While price forecasts aren’t definitive, it’s very telling that even the lowest target price is considerably higher than the stock’s current trading price. This suggests ample upside potential, even if the stock doesn’t hit the median target price.

 

Taking the stock’s low pricing multiple into account, this level of potential growth makes Discover a very appealing value buy.

 

Of course, Discover also has some risks associated with it. To begin with, the company’s exposure to digital banking can be a liability when default rates increase.

 

Unlike competitors that mostly collect fees for processing payments, Discover actually risks capital on loans. In the event of higher default rates, this can have a significant impact on the company’s bottom line.

 

Discover also carries a slightly high debt-to-equity ratio. At the time of this writing, the ratio was 1.509, which is at the outer edge of the generally accepted safe debt-to-equity range.

 

This number, however, doesn’t tell the whole story. The company’s debt-to-equity ratio has been trending steadily downward since hitting 3.174 in September 2020. While it has increased slightly in the most recent quarter, the general downward trend seems to show Discover regaining control of its debt load.

 

Overall, Discover looks to be a strong value buy, especially as inflation and interest rates continue to rise. While its slightly high debt load and default risks present some cause for concern, the company’s strengths heavily outweigh its weaknesses.

 

Excellent growth prospects, favorable pricing and a clear path to increased profitability in a higher interest rate environment all support a bullish outlook for Discover.

 

Although inflation will likely eat into returns for the foreseeable future, Discover is one of the better stocks to buffer your portfolio against it. Even if the stock only reaches the lowest analyst price target for the next 12 months, its 15 percent should keep it well ahead of the rate of inflation.

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