Capital one, the bank holding company specializing in credit cards, was grouped among stocks that appear to have benefited well from the pandemic. As a result, its stock price has risen around 36% over the past year and although it is not trading at all-time highs, it is still trading at much higher levels than before the pandemic. .
Given the stock’s strong performance, why could Capital One be considered a value play? Perhaps it’s the fact that it has continued to trade at a discount to many of its credit card peers – and at fairly low multiples.
Let’s see if Capital One may be undervalued compared to its peers and if it is worth considering as a potential investment.
Why is this a discount?
Whether you’re looking at stock price relative to earnings or tangible book value (what a company would be worth if it went into liquidation), Capital One trades at a discount to its peers. And it’s been doing this for a while. Here is a summary of the current state of valuations.
|Society||P/E ratio (TTM)||Price/Tangible Book Value|
|Capital one (NYSE:COF)||5.9||142%|
|Discover financial services (NYSE: SDF)||seven||273%|
|Synchrony Financial (NYSE: SYF)||6.1||221%|
|American Express (NYSE:AXP)||19.7||678%|
The metrics are a bit closer between Capital One and Discover and Synchrony on a price-to-earnings basis, but still far apart on the tangible price-to-book ratio. This would suggest that the price of the stock is cheap. This begs the question: is there a good reason for this cheaper valuation?
I think there are a few things to explain the reduction over the years. A good metric to use when valuing bank stocks is return on equity, which shows the return a company generates on shareholder capital. It’s not just important to deliver a strong return on equity, but to do so consistently and with as little volatility as possible. As shown in the chart below, Capital One has consistently generated a lower return on equity than its peers.
Similar but different
Capital One operates in three main segments: It has a credit card business for consumers and small businesses in the United States and internationally; it has a consumer banking business, which includes auto loans, deposit accounts, and lending products for consumers and small businesses; and it has a commercial banking business. Synchrony’s business is based on what it calls a partner-centric model in which it partners with leading retailers and brands across a number of industries to provide finance and credit solutions. often at the point of sale.
Discover offers a variety of consumer loan products, including credit cards, personal loans, student loans, and mortgages, as well as payment capabilities. American Express has created a closed-loop payment system where it issues its American Express-branded cards to consumers, but also manages the merchant acquiring side of the business where it helps businesses accept and process transactions at from American Express cards.
So, while all of these companies are in the business of credit cards, they are not the same. American Express works much like other payment rails such as Visa and MasterCard — companies that receive higher multiples. Capital One will probably never trade at these kinds of multiples.
Although its large credit card portfolio separates it from most traditional banks, Capital One’s automotive and commercial banking business draws it more toward a traditional bank than some of its peers. Its overall margins are lower than those of Discover and Synchrony. These smaller margins should ideally give the company an advantage in seeing lower levels of loan losses due to commercial and automotive activities. But investors may want to wait and see how the company holds up in the coming rate cycle, especially with soaring car prices.
What should happen
Another thing to note in the chart above: Capital One’s return on equity jumped in 2021. This change was not uncommon in the industry as many banks released previously set aside capital for loan losses expected from the pandemic but never materialized. Banks have also benefited from Paycheck Protection Program loans during the pandemic. However, both of these events come to an end and do not happen again, so the earnings power generated by Capital One in 2021 is unlikely to be sustainable going forward.
The good news for Capital One is that loan growth, particularly in the area of credit cards, has returned. Domestic credit card loan balances increased 10% in the fourth quarter of 2021 compared to the prior quarter. Management didn’t provide much guidance on expected loan growth, but acknowledged that prepayment rates were still high through the end of 2021. So that could have dampened loan growth, although , on the other hand, the strong prepayment rate keeps credit quality very strong. I also think Capital One has a much better capital structure than in the past, and the company has bought back a lot of stock.
Takeaway for investors
Going back to my original question, I don’t currently view Capital One as a pure value play and can understand the company’s discount to its peers. That said, trading at 142% of its tangible book value makes me believe this stock has a long-term upside. Capital One must effectively manage credit quality through the coming rate cycle, take advantage of loan growth opportunities, and ultimately generate higher risk-adjusted returns on capital.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.