DFS is a company that generates ~$1B per year in free cash flow and currently trades at book value. Of the underlying drivers of firm value (i.e., top-line growth, ROIC, and cost of capital) the most concerning to me is ROIC. This begs the question: at today's price, what is the market's assumption for free cash flow growth over the next four years? If we assume a near worst-case scenario (widespread fraud and bankrupcty would be the worst--though my opinion does not support this) of 4 consecutive years of only $500m in free cash flow--a fifty percent reduction driven mainly by a huge increase in the current charge off ratio of 5%, followed by a return to $1B of cash flow generation followed by a valuation of 10x cash flow in year 10, the value of the company would be ~$10B vs today's current value of $6B. Clearly, the market is seeing a longer period of uncertainty since the implied cash flows out 4 years are being valued at zero! Or, DFS is being overly discounted during the current economic crisis. My guess it that the charge off ratio will grow as high as 10% but in the end most folks will pay their bills.
Quick Snapshot
Pricing Power: yes
Oligopoly: yes
Recurring Revenue: yes
Brand Strength: so-so
ROIC > Cost of Capital: yes
Balance Sheet Strengh: A
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