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This is Part 4 of a series of articles discussing the returns on common stock and TARP warrants for a few financial institutions relative to the institution's book value. In this article, I am looking into JPMorgan (JPM). Part 1, on AIG (AIG), is located here. Part 2, on Bank of America (BAC), is located here. Part 3, on Citigroup (C) is located here. Also, Part 4, on Wells Fargo (WFC) is located here.

JPMorgan received roughly $12 billion during the 2008 financial crisis from the government to help keep the bank operating. During the crisis, JPMorgan also purchased Bear Stearns.

The company recently reported earnings. A highlight of the earnings report was a third consecutive year of a 15% return on tangible common equity. The bank also flaunted its 'fortress' balance sheet. Many large banks now refer to their balance sheet as being a 'fortress' but JPM coined the term and does maintain a particularly strong balance sheet. The company also reported a Basel III Tier 1 ratio of 8.7%.

The biggest drawback of the company is the recent 'London Whale' incident. This showed that even the best run institutions can be susceptible to enormous losses resulting from an individual's actions. The company has booked losses in excess of $6 billion as a result. Also, like other banks, JPMorgan has been targeted with numerous lawsuits relating to foreclosures resulting from mortgages the bank originated. The latest settlement resulted in a nearly $2 billion charge, $753 million of that is a cash charge.

A downside of the company's reputation as one of the best run banks is that it has set a high bar for performance so it will need to continue to beat expectations to justify the high price. An illustration of this is the most recent earnings report, which was good - but not good enough for a rally in the shares. On the other hand, Bank of America and Citi reported significantly worse numbers and the shares only fell a few percent. That shows the level of expectations placed on different companies. Lastly, JPM has already reduced costs and now could lose some of its investor base as investors shift to banks that are able to cut costs and streamline operations which would help the JPM beat expectations. The company has already done this so it faces a negative mean reversion.

As the bank moves past the lawsuits and the yield curve moves back towards normalized levels, the bank's valuation should return to more normal levels relative to book value. A steepening yield curve will help the bank earn a normal return on its book, which will make the price to book metric relevant again.

As I assumed with Wells Fargo, a long-term valuation of 1.6x book value in 2018 seems too low. The bank already commands a higher than average valuation, so I expect the valuation gap to continue into the future. For a bank as well run as JPMorgan (though without the new growth of Wells Fargo), a valuation of around 1.8x book value seems more reasonable. The bank is currently trading at roughly 1.3x book value. The 5 year average book value for the company is 1.7x - and it has been quite a difficult 5 years. For that reason, I think the valuation of 1.8x book value, once the negative aspects I highlighted above are no longer present, is reasonable.

In the table below, I list the relevant information about the warrants, the current stock price, the current stated book value (from the latest quarterly report), and two scenarios for warrant and stock returns based on price relative to future book value. I assume book value grows at 3.5% per year from current levels. This is a low growth rate to keep the analysis conservative.

JPMorgan Warrant (JPM.WS)JPMorgan Common Stock (returns calculated until warrant exp.)
Warrant Strike Price$42.42--
Warrant Price$13.85--
Warrant Exp. Date10/28/2018--
Time until expiration (years)5.73--
Current Stock Price$47.84$47.84
Current Book Value per Share$51.27$51.27
Price if stock trades at 1x BV which grows at 3.5% per year till expiration$20.02$62.44
Historical P/B Ratio1.81.8
Price if stock trades at historical P/B & growth in BV of 3.5% per year$69.97$112.39
Return if stock at BV45%31%
Return if stock at historic P/B, 2.0x405%135%

These warrants do have a form of dividend protection. As the quarterly dividend rises above $0.38 per share, the strike price of the warrants is adjusted down by any amount over the threshold. The company currently pays a dividend of $0.30 per quarter. I expect JPMorgan to gain approval for a dividend increase and potentially a share buyback from the Fed in March of this year. I assume the dividend gets increased to $1.32 annually this March, a 10% increase over current levels. From that level, the dividend continues to be increased at 8% per year until the warrants expire. Under that scenario, the dividend grows above the adjustment threshold in 2015. Throughout the life of the warrant, the strike is adjusted down by a total of $0.75. Also, a total of $9.20 in dividends is paid out to shareholders. The table below presents the returns for the stock and warrants with dividends included.

Returns with Dividends as Calculated Above
JPMorgan Warrant (JPM.WS)JPMorgan Common Stock (returns calculated until warrant exp.)
Total Dividend Paid (through 2018 Q3)$9.20$9.20
New Warrant Strike Price$41.67--
Price if stock trades at 1x BV which grows at 3.5% per year till expiration$20.77$62.44
Historical P/B Ratio1.81.8
Price if stock trades at historical P/B & growth in BV of 3.5% per year$70.72$112.39
Return if stock at BV (including dividends for common stock)50%50%
Return if stock at historic P/B, 2.0x (including dividends for common stock)411%154%

On a return to 1.8x book value, a reasonable expectation given the nearly 6 year time horizon, the warrants return a surprising 405%, or 31% annually. Over the same time period, the stock returns 135%, or 16% annually including dividends. As you can see from the table above though, the warrant returns are very high as long as the bank receives a significant premium over book value. If the stock maintains the current ratio or a lower ratio, the warrants will face much smaller gains, or even losses.

The warrant returns are so high because of the high dollar-value of the company's book value per share. An increase of 0.5x book value results in a $25+ increase in the stock price.

If you are positive on JPMorgan going forward and believe the company can maintain the premium it demands amongst other banks, the warrants will have a significantly higher return than the common stock. If the company loses its premium though, the warrant returns will be lower than expected (or possibly negative). Keep in mind that the majority of the warrant value is time value which is subject to decay.

The common stock is a more conservative way to gain exposure to the company. Also, even if the dividend is slower to reach the warrant adjustment threshold than I calculate, the stock will still benefit from the cash returned to shareholders.

One drawback of the warrants is that they are more illiquid than other warrants, with a bid/ask spread often over $0.05 or $0.10. As a result, any impatient investors will have to pay the spread to get into a position quickly. With wide bid-ask spreads, it's best to be patient and choose a level where you are comfortable owning the warrants and wait for the market to come to you.

Since the company has recently reported earnings, investors have a good current picture of the company's fundamentals. The stock has had a big run over the past few months but starting a position at current levels seems reasonable as long as investors can wait to purchase their remaining stake until market conditions result in lower prices.

Source: JPMorgan Stock And Warrant Returns Relative To Book Value

Additional disclosure: I am long JPMorgan via the warrants discussed in this article.