Capital One (COF) announced plans to acquire Discover Financial Services (DFS) in a $35 billion all-stock transaction on February 19, 2024.

The combination of the two leading credit card issuers will create the largest player in the U.S. card market by outstanding loan balances.

Under the terms of the agreement, Discover shareholders will receive 1.0192 shares of Capital One stock for each Discover share owned. Based on Capital One’s stock price of $105 per share at the time, this implies a price of around $140 per Discover share—representing a premium of over 26% to Discover’s closing price on February 17.

Discover has a strong track record of profitability, generating around a 25% Uniform return on equity (‘‘ROE’’) consistently until being impacted by the COVID-19 pandemic in 2020.

Take a look…

We can see the true value of Discover’s franchise is higher than the current acquisition price if its historical profitability is factored in.

Capital One expects to realize over $2.7 billion in pre-tax cost synergies by 2027 by eliminating duplicative operations and improving combined margins.

With a 27% share of the U.S. card market, the merged entity will have unparalleled data assets and insights to power product innovation.

Significant network synergies are also anticipated. While Discover has its own payments network, Capital One credit cards can now utilize this infrastructure.

The deal also provides opportunities for regulatory relief by gaining more negotiating power with merchants on swipe fees.

The transaction is expected to close by the end of 2024 or early 2025, subject to regulatory approvals.

Despite these factors, the market is concerned about consumer health and their ability to pay their debt.

We can see what the market thinks through our Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at a company’s current stock price. From there, we can calculate what the market expects from the company’s future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

At the current stock price, the market expects the company’s ROE to fall to around 6%, below the pandemic levels.

By acquiring Discover, Capital One is purchasing a high-quality business that was rebounding strongly from the pandemic effects. The combination creates a financial powerhouse with massive scale advantages.

The market’s concerns should not overshadow the fact that this deal will create the largest U.S. credit card company by loan volume, potentially offering a huge equity upside when the smoke clears.

We can bet on the long-term upside from the company’s increased market dominance despite the macroeconomic uncertainty.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.