Why JPMorgan Could Double By 2018

Feb.19.13 | About: JPMorgan Chase (JPM)

Overview

JPMorgan Chase & Company (NYSE:JPM) reported record full-year earnings for 2012 last month. The fourth quarter saw net income of $1.39 per share, contributing to full-year earnings of $5.20. The report marked the third consecutive year that JPM has posted record earnings and included a very strong 15% return on tangible common equity. As is customary these days with too-big-to-fail banks, the earnings report was riddled with litigation and non-operating items that distorted JPM's results. The stock has since traded up about $2 after an initial small dip in the shares right after the earnings report. With the stock trading at nearly $49 today, the question for investors is, is JPM still a solid place to park your capital?

Earnings Items

As I said, JPM's report was littered with what I consider to be noise in its earnings report. Among the highlights:

Item

After-Tax Impact Per Share

Mortgage-related matters, predominantly the Independent Foreclosure Review settlement

($0.14)

Debt Valuation Adjustments

($0.09)

Tax Adjustments in Corporate

$0.16

Reduced Mortgage Loan Loss Reserves

$0.11

Total

$0.04

Click to enlarge

What we can see from this table is that JPM's earnings did have some GAAP nonsense in it but fortunately, the aggregate impact was almost meaningless, at only 4 cents per share. This is in stark contrast to JPM's TBTF brethren Citigroup (NYSE:C) and Bank of America (NYSE:BAC), both of whom have seen their earnings whipsawed since the financial crisis with various non-operating items. This is one thing that sets JPM apart from the other TBTF banks as JPM came out of the financial crisis years ago while its competitors are still in turnaround mode. JPM is operating almost as though the financial crisis never happened, hitting on all cylinders as we saw with the 2012 year-end report.

Valuation

In an attempt to assign a value to JPM shares, we'll use a DCF-type model in which some assumptions must be made. Those assumptions are: 1) 2012 - 2014 earnings, 6% earnings growth estimates as well as book value are all from Yahoo! Finance analyst compilations 2) Perpetual earnings growth of 3% is my number 3) Dividend growth is assumed to be 5% per annum, also my number 4) The model does not take into account share repurchases as they are impossible to forecast 5) Discount rate used is 9%, which is also my number.

You may disagree with the efficacy of some or all of my assumptions but any forecast is inherently subject to conjecture.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$5.20

$5.42

$5.77

$6.12

$6.48

$6.87

x(1+Forecasted earnings growth)

4.23%

6.46%

6.00%

6.00%

6.00%

6.00%

=Forecasted earnings per share

$5.42

$5.77

$6.12

$6.48

$6.87

$7.28

Equity Book Value Forecasts

Equity book value at beginning of year

$51.23

$55.39

$59.84

$64.56

$69.59

$74.93

Earnings per share

$5.42

$5.77

$6.12

$6.48

$6.87

$7.28

-Dividends per share

$1.20

$1.26

$1.32

$1.39

$1.46

$1.53

$1.61

=Equity book value at end of year

$51.23

$55.39

$59.84

$64.56

$69.59

$74.93

$80.61

Abnormal earnings

Equity book value at begin of year

$51.23

$55.39

$59.84

$64.56

$69.59

$74.93

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

$4.61

$4.99

$5.39

$5.81

$6.26

$6.74

Forecasted EPS

$5.42

$5.77

$6.12

$6.48

$6.87

$7.28

-Normal earnings

$4.61

$4.99

$5.39

$5.81

$6.26

$6.74

=Abnormal earnings

$0.81

$0.78

$0.73

$0.67

$0.61

$0.54

Valuation

Future abnormal earnings

$0.81

$0.78

$0.73

$0.67

$0.61

$0.54

x discount factor(0.09)

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

$0.74

$0.66

$0.56

$0.48

$0.40

$0.32

Abnormal earnings in year +6

$0.54

Assumed long-term growth rate

3.00%

Value of terminal year

$9.01

Estimated share price

Sum of discounted AE over horizon

$2.84

+PV of terminal year AE

$5.37

=PV of all AE

$8.21

+Current equity book value

$51.23

=Estimated current share price

$59.44

Click to enlarge

As we can see, my model suggests that the long-term present value of JPM is currently around $59 per share, or roughly 22% higher than today. This reflects JPM's ability to grow earnings and increase dividends over the long term, given its extremely strong position now. In addition, since buybacks are not included in my analysis but are almost assuredly going to occur, that should provide a tailwind for shares in the future, offering upside risk to my forecast. I won't read the table to you but highlights include a 2018 book value forecast of $80 per share and earnings of over $7 per share that same year. Given that JPM is currently trading for $48.88, my earnings and book value forecasts imply a share price in the $70 to $80 range over the next five years.

In this chart, we can see that JPM had historically, prior to the financial crisis, traded at a premium to book value.

Considering that JPM is currently trading at about a $3 per share discount to book value, significant upside is implied in the share price given the fact that book value has continued its relentless climb upward.

In addition to this, JPM has experienced return on assets of 0.86% in the past year, off from a historical high of almost 1.25% before the financial crisis. JPM appears to be well on its way to resuming 1%+ ROA numbers and assuming this occurs, JPM's $2.359 trillion in assets implies another $3.3 billion in net income if JPM only gets back to 1% ROA and $9.2 billion if JPM can attain 1.25% ROA.

The main point of this graph is that JPM has the magical formula of rising assets and rising return on assets. This means that book value and profits should continue to grow unabated in the coming years, barring some exogenous shock.

In this final metric, we see that JPM has experienced return on equity of 10.73% in the past year. This is a discount to the historical top end of the range of about 15% ROE. If JPM can capture that 400 bps of additional ROE, it would imply an additional $8 billion of net income for shareholders.

Of course, 400 bps of ROE doesn't come easily and this is likely to happen over several years. However, the main point is that ROE is on the rise and has room to run before it is even back to its historical highs. In addition, JPM has rising equity value while ROE is also rising. Again, this is perfect for shareholders as the return on their equity is going up while the base that the returns come from is also rising. This implies billions of dollars of additional net income is possible for JPM in the coming years, offering substantial upside risk to my forecast and the forecast of analysts that follow JPM.

Conclusion

JPM has come out of the financial crisis as the undisputed leader in money center banking. The company has a reputation that is the gold standard among commercial banks and deservedly so. In addition to focusing on core banking operations and profitability, the company has the best CEO in banking in Jamie Dimon. He has moved the company past the London Whale incident that cost shareholders roughly $6 billion and that catastrophe is now a hiccup in an otherwise stellar year for JPM. The company is downsizing riskier operations and concentrating more on its banking operations that have proven to be more stable over the past few years. In addition, some new legislation that promises to streamline the refinancing process could prove to be a boon for JPM's mortgage operations.

The company has a long history of profitable operations with a very strong reputation among its customers and has the undisputed best CEO in the industry. If JPM can return to a level of profitability close to levels experienced before the financial crisis, we should see share prices much higher in the next five years. In fact, if JPM hits the historical highs of ROA and ROE, given the growth in assets and shareholders' equity, I wouldn't be surprised to see JPM double by 2018.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JPM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.