I have been bullish on common equity shares of Wells Fargo (WFC), and the market, for the past several months. Common equity shares of the financial services firm have increased substantially in value during the past few months. It could be time for investors to scale back their long equity position as shares of the firm may be overvalued. If we can accurately assess the firm's relative value and take the appropriate action, we can achieve better risk-adjusted returns.
To assess relative value, you determine the current valuation of the firm. We'll use the price-sales ratio and price-earnings ratio to determine current value. Next, you forecast financial performance based on historic performance making adjustments for trends and anticipated structure changes within the firm and the industry. That said, based on the recent increase in the share price, Wells Fargo may be overvalued.
To determine if a firm is overvalued, a level or zone determines if the company's valuation is too high. Personally, I wouldn't buy shares of a company with a valuation at or above 3 times sales; also, I wouldn't purchase shares of a cyclical company during an economic expansion with a valuation at or above 16 times earnings. We'll use a financial forecasts and some macroeconomic analysis to assess equity valuation.
Macroeconomic factors are key determinant of equity valuations. As usual, I'll briefly cover the macro themes dominating the markets. Well, central banks around the world are adding monetary stimulus to guard against recessionary output levels. Also, fiscal consolidation remains a central theme. Overall, general business conditions continue to improve.
Total Interest Incomes & Net Interest Incomes
Between 2003 and 2009, total interest income almost tripled; it peaked in 2009, and it declined every year since. Total interest income declined 2 percent in 2012 compared with 2011; the pace of decline slowed from 6 percent. Total interest income increased at an annual compound growth rate of 10.7 percent.
Net interest income on a tax-equivalent basis peaked in 2009, and it declined every year since. Between 2003 and 2011, net interest income increased at a compound annual growth rate of 13.2 percent. The 2012 tax-equivalent number hasn't been released.
The net interest income-total interest income margin is trending higher, and it stood at 88 percent at 2011's end. The 2012 margin is probably 89 percent. That is an increase from a low of 60 percent at 2007's end, and an increase from 83 percent in 2003.
Interest income is a key driver of net income: Total non-interest income has not been larger than total non-interest expense recently.
Total Non-Interest Incomes & Revenues
Total non-interest income peaked in 2009 and declined until 2012. In 2012, non-interest income increased 12 percent to $42.86B. Between 2003 and 2012, non-interest income increased at an annual compound rate of 14.8 percent. A large part of the increase was acquisition related.
Revenue, net interest income and non-interest income combined, is trending higher. In 2012, revenue increased 6.3 percent to $86.09B following two years of declines. Revenue increased at an annual compound growth rate of 13.1 percent.
Net Incomes, Dividends & Shares Outstanding
Net income and net income applicable to common shareholders roughly tripled between 2003 and 2012. Net income increased at a nominal annual compound growth rate of roughly 13 percent.
In 2008, the company started paying dividends to preferred shareholders.
The net income-revenue margin was 20 percent to 24 percent. The net income applicable to common shareholders margin is slightly less. The company pays roughly $800M to $1B per year in preferred share dividends.
Net income applicable to common shareholders increased almost 20 percent to $18B in 2012.
There are issues comparing the dividend in 2003 with today's dividend to common shareholders. That said, more recently the dividend has been increasing. This year the dividend should be $1.00 per share. Next year I am forecasting a dividend of $1.40 per share, which is roughly the 2008 level.
Average common shares outstanding more than tripled since 2003. The compound growth rate is 13.6 percent. Investors would have to increase the quantity of shares held to maintain their ownership interest.
Full-Year 2013 Forecast
I'm forecasting full-year total interest income in the $45B to $52B range. Using a 87 to 91 percent margin, interest income should be in the $39.15B to $47.32B range.
Total non-interest income should be in the $35B to $41B range. Thus, net income applicable to common shareholders should in the $13.09B to $20.4B range, assuming a net profit margin in the 19-24 percent range.
First-Quarter 2013 Forecast
I'm looking for total interest income in the $11.5B to $12.2B range and net interest income in the $10B to $11.1B range. Also, total non-interest income in the $10B to $11.6B range. Finally, net income applicable to common shareholders should be in the $3.8B to $5.45B range.
Risk & Return Profile
We'll use to the monthly returns from the 2000-2012 period to analyze the risk and return profile. The time-series arithmetic mean monthly nominal return was 1 percent. The time-series median monthly nominal return was 0.8 percent.
One of the nominal monthly returns was between -40 percent and -35 percent. Eight of the nominal monthly returns were between -15 percent and -10 percent. Nine of the nominal monthly returns were between -10 percent and -5 percent. Thirty-eight of the nominal monthly returns were between -5 percent and 0 percent. Sixty-one of the nominal monthly returns were between 0 percent and 5 percent. Twenty-five of the nominal monthly returns were between 5 percent and 10 percent. Twelve of the nominal monthly returns were 10 percent or greater.
About 25 percent of the nominal monthly returns were between -5 percent and 0 percent. Further, 39 percent of the nominal monthly returns were between 0 percent and 5 percent. A little over 5 percent of the nominal monthly returns were between -15 percent and -10 percent. Finally, 16 percent of the nominal monthly returns were between 5 percent and 10 percent.
That said, 37 percent of the nominal monthly returns were between -40 percent and 0 percent. That means the other 63 percent of the nominal monthly returns were 0 percent or higher. The modal interval was 0 percent to 5 percent.
The time-series geometric mean nominal monthly return or time-series nominal monthly compound growth rate was 0.6 percent. The nominal geometric mean monthly return on a bond equivalent basis was 7.2 percent. The nominal geometric mean monthly return on an effective annual yield basis was 7.4 percent.
We'll make a statistical inference about the population geometric mean nominal monthly return. The population geometric mean nominal monthly return at 95 percent confidence, assuming a standard normal distribution, was between 1.97 percent and -0.77 percent.
Wells Fargo's nominal monthly return distribution was positively skewed and leptokurtic.
The share price used for the valuation was $35.14. That said, total interest income in 2012 was $48.39B and average basic shares outstanding was 5.29B. The current share price-total interest income ratio is 3.84.
Using my forecast for 2013 total interest income, and a forecast of 5.3B average basic shares outstanding in 2013, I calculate a forward price-total interest income ratio ranging from 3.58 to 4.14.
On a price-total interest income basis, Wells Fargo is overvalued.
In 2012 net income applicable to common shareholders was $18B. The current share price-net income ratio is 10.34.
Using my forecast for 2013 net income applicable to common shareholders, I calculate a forward price-net income ratio ranging from 14.23 to 9.13.
Wells Fargo is a cyclical company: cyclical firms typically have lower price-earnings ratios during periods of economic expansion. On that basis, I determine that on a price-earnings basis Wells Fargo is fairly valued.
Thus, I consider Wells Fargo to be fairly valued to overvalued.
Shares of Wells Fargo are trading above the rising 50-day simple moving average: In other words, the intermediate-term trend is toward higher prices. There is resistance in the $35-$36 zone.
We are seeing some longer-term momentum divergences: We could see a substantial throwback at some point; however, price confirmation is absent.
Financial firms outperformed energy firms and technology firms during the past several months.
All of that said, we remain in a Dow theory defined bull market.
Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.