Better Buy: Visa Inc. vs. Discover

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When someone reaches into his or her wallet and pulls out a credit or debit card to pay for a purchase, there are only a handful of card brands likely to emerge. For an investor hoping to profit off of these digital transactions, the stock of either Visa (V -0.70%) or Discover Financial Services (DFS -1.31%) could be the right choice.

The question, then, is, which one is the better buy today?

Visa and Discover may seem similar, but they're actually very different

Visa is a payment processor. Every time someone swipes a Visa-branded credit or debit card, Visa earns a small fee on that transaction. Visa is not, however, a bank. It does not lend money to its customers. Instead, investors should think of Visa more as a transaction toll collector. Transactions travel along the highway between a merchant and a bank, and Visa simply sits in the middle facilitating the transaction and collecting fees on every purchase that comes down the road.

Discover is also a payment processor, collecting fees whenever a Discover card is used for a purchase. Unlike Visa, however, Discover is a bank. Discover credit cards actually represent debt that the borrower owes to Discover. In addition to credit cards, the company makes personal loans and student loans, and offers deposit products and other financial services you'd see at a traditional bank.

This is a very important distinction that impacts the structure of the two companies' financial statements, their valuations, and ultimately, your decision to invest in one or the other.

Therefore, Visa's and Discover's financial statements also look quite different

The impact of these business-model differences are plain to see on each company's financial statements. Discover's portfolio of loans makes it a much more capital-intensive business, and that in turn lowers the company's ability to generate returns relative to its assets. Visa, being a transactional business, is much less capital-intensive and generates much higher returns on assets.

The flip side, though, is that Discover's banking business allows for greater use of leverage. That boosts the company's return on equity, bringing it to a level on par with Visa's. It also makes the bank much more sensitive to interest rate risk, as evident by its declining returns on equity and assets since the financial crisis and the resultant low interest rate environment.

V Return on Equity (TTM) data by YCharts.

From a growth perspective, Visa's numbers are far better than Discover's. However, I see this as much as a reflection on the different business models as anything else. Discover's growth must be more conservative, or else it risks lowering its credit standards to a point that could cause the company severe long-term harm if the economy faltered. Its higher leverage also adds additional risk that requires prudence over growth. Visa has no such constraints, allowing it to aggressively pursue innovative growth strategies with little concern for credit risk or otherwise.

V Revenue (Quarterly) data by YCharts.

Visa's business model earns it a much richer valuation compared to Discover

Visa and Discover make money for their investors in different ways, and because of that, the market values each differently. While not exactly apples and oranges, comparing their valuations side by side is not a very helpful exercise. Visa currently trades at 34 times it trailing 12-month earnings, compared to Discover's 10.6 times.

Visa's valuation is so much higher for many of the reasons already discussed here. The company's returns on equity are better, it is growing faster, and it has better margins. That alone doesn't mean the stock is a better investment -- it just means that the companies are different.

A better comparison for Visa is MasterCard (MA -0.74%), which has a comparable business model and trades at 28.7 times its trailing 12-month (TTM) earnings. For Discover, a more direct comparison would be American Express (AXP -0.97%) because of its hybrid lending-payment processing model. American Express trades at 11.3 times TTM earnings.

In both cases, each stock is valued similarly to its closest peer, with each having pluses and minuses in terms of growth, returns, and value. The valuation of neither Visa nor Discover appears to be grossly off base.

So which stock is the better buy, Visa or Discover Financial Services?

Taking into account each company's business model, financials, and valuation, I think that Visa is the better buy.

I think that Visa's "toll collector" business model is less risky, better suited for rapid growth, and more profitable than Discover's hybrid bank-payment processor model. I also prefer Visa for its lower leverage and the lack of credit risk. Taken all together, these factors justify paying the higher premium and owning Visa over Discover.