Capital One: A Value Stock In A Value Less World

Capital One (NYSE: COF) is a financial services company. It is essentially a holding company for various financial services, the largest of which is the Capital One Bank. The company’s primary businesses include credit cards, consumer banking, and commercial banking. The company mainly operates in the US. However, it also has reasonably extensive operations in the UK and Canada. What’s interesting, though, is how the company is adequately priced in a massively overvalued market.

Don’t Stop Doing What Works

With the markets at or near their all-time highs worldwide, it is no surprise that value investors are having a tough time. That is where Capital One comes in, as it is a stock priced adequately and has enough going for it to increase its price in the future.

The company was founded in 1988, and it went public in 1994. Although it was initially solely a credit card company, it has since added commercial and consumer banking to its portfolio of services. These three businesses form the vast majority of the company’s revenue, with credit cards being the activity that the company is most known for. Despite COVID-19, the company has managed to continue its trend of modest but consistent revenue growth.

For the future, the company has a two-fold strategy. The first is to continue its three primary businesses. According to the company, its banking operations including digital such as Capital one 360 and credit cards are going to continue growing at a steady pace well into the future. There is no reason to change something that has worked so well in the past, is there? The second is to find new sources of revenue. To do this, the company is tapping into the internet through products. One of them is Capital One Shopping, a browser extension that allows consumers to save money when shopping online. 

While the new businesses form an insignificant portion of the company’s sales, they are an exciting long-term initiative from an investor’s point of view.

It’s All Relative

Despite the massive increase in S&P 500’s average P/E ratio, Capital One is still priced relatively similar to its historical earnings level

 

At the time of writing, the average P/E ratio of the S&P 500 is hovering between 35 and 36. Compare this to Capital One’s modest P/E ratio of 6.43, and you begin to see why Capital One is so enticing from a value investor’s perspective.

Capital One is priced so low because net income is expected to fall in the next few years, according to consensus estimates, the expected earnings for FY22 are $6.7bn, a far cry from the over $10bn expected for FY21. This is mainly due to an increase in provisions for loan losses from $6.2 to $10.3 billion due to an increasing default risk. However, other metrics show that the company is in a healthy financial position.

For example, the company’s revenues are expected to rise well into the future, with an almost 10% increase expected in FY23 over FY22. The price to book ratio, currently at 1.24, is expected to fall to 1.04 in FY22 and 0.97 in FY23. Lastly, the company is expected to pay a higher dividend over the next few years. The dividend was $1 per share in FY20, but it is likely to stay in the $2.4-2.6 range for the foreseeable future. 

Is Capital One Right for Me?

You may be thinking that Capital One is a vastly underpriced stock that you should pick up immediately. However, it is only suitable for certain kinds of portfolios.

Capital One is underpriced because investors do not expect exponential growth from the stock, and they are 100 per cent correct. With no ‘revolutionary’ products in its pipeline, Capital One is expected to continue on the same trajectory that it has been on. However, that also means that the company is less prone to market downturns and recessions.

Conventional wisdom dictates that highly valued companies take the biggest hit in a stock market downturn. Companies like Capital One, on the other hand, take a much shallower dive during difficult times. The company’s business model is also reasonably recession-proof, as modern finance will always require credit and banking facilities. Capital One offers wide range of credit card options for different types of customers and great online experience which expected to support the company in the next few years.

Sure, the company has almost $38 billion in debt. However, it has an almost equal amount in cash too, allowing its leverage to not be a problem. In fact, with a book value per share of over 130, there is a high margin of safety when it comes to investing in the company. During COVID-19, the company’s stock price declined more so than the financial sector average. However, we believe this was due to the sudden death of business activity that lead investors to believe that the company’s customers would default on its debt. Since that did not happen, the company’s stock price bounced back rather quickly.

We believe that the company’s highly leveraged position is its biggest risk. However, this only becomes a problem in case of a financial crises like the one we saw in 2008. Unless a significant percentage of the company’s customers default on their debts simultaneously, Capital One should continue to operate as normal.

It seems that Capital One, as a credit card company, picked the right countries to operate in.

 

According to data by SHIFT Credit Card Processing, the three countries with the highest credit card debt are the USA, UK, and Canada, the primary jurisdictions where Capital One operates. The company has a 10.4% market share in the US, and is a small but significant player in the UK and Canadian industry.

On top of that, according to forecasts from the Federal Reserve, credit card debt is expected to rise in 2022 and beyond. Keeping this in mind, it is safe to assume that while Capital One will not experience massive gains, it won’t experience considerable losses either.

As such, Capital One is an decent stock for those looking to hedge their portfolio against a market downturn. If you own many stocks with a high valuation, Capital One could help you manage your risk. However, if you are looking for stocks with immense growth potential, Capital One may not be for you.