Capital One May Rocket 22% As Discover Holds Flat

| About: Capital One (COF)

Over the last five-year, one-year and six-month periods, Capital One Financial (NYSE:COF) has underperformed its competition. It has lost two-fifths of its value from five years ago and, despite having dramatically transformed, still has structuring issues. I believe that the company would make an ideal activist target, excluding the market cap. The stock currently believes that it - in addition to Discover Financial Services (NYSE:DFS) and Citigroup (NYSE:C) - is a "buy." Based on my review of the fundamentals and multiples analysis, I find particularly high risk-adjusted return potential for Capital One.

From a multiples perspective, Capital One is the cheapest of the three. It trades at a respective 7x and 7.4x past and forward earnings with a dividend yield of 0.4%. DFS and Citigroup, meanwhile, trade at a respective 7.2x and 8.7x past earnings. To put this into perspective, consider that Capital One is only valued at 76% of its historical five-year average PE multiple:

At the forth quarter earnings call, Capital One's management noted:

"Capital One earned $407 million or $0.88 per share in the fourth quarter of 2011. We saw strength in loan growth and stable revenue. Earnings declined, however, due to increases in non-interest and provision expense, the latter reflecting stabilizing credit trends. There were an unusual number of unique items impacting revenue and operating expense, which I'll review in a moment.

While full year 2011 results also had some noise, they provide a somewhat clearer picture of where we stand as we approach the integration of ING Direct and U.S. Credit Card business of HSBC in the first part of 2012."

Since the recession, the company has transformed itself into a diversified commercial bank and is now making a stab at online banking. While many of the decisions were strategically attractive, I am reserved about how accretive the ING Direct and HSBC card business will be in the near and intermediate future given their profitability. But from a risk perspective, Capital One is strong as a financial, since the firm's solid balance sheet and strong brand hedges against a double dip.

Consensus estimates for Capital One's EPS forecast are that it will decline by 14.1% to $5.84 in 2012 and then grow by 14.9% and 12.1% in the following two years. Assuming a multiple of 9x and a conservative 2013 EPS of $6.64, the rough intrinsic value of the stock is $59.76, implying 21.5% upside.

DFS benefits from economies of scale and the sustainable streams of free cash flow driven by its loyal clients. It also offers an attractive medium for investors to gain exposure to global payment processing. Risks include margin pressures from member banks and financing uncertainty. Consensus estimates for DFS' EPS forecast are that it will decline by 17.2% to $3.36 in 2012 and then grow by 0.3% and 6.8% in the following two years. Assuming a multiple of 9x and a conservative 2013 EPS of $3.33, the rough intrinsic value of the stock is $29.97, implying 3.3% upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.