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JPMorgan Chase (NYSE:JPM) shares have bounced strongly from the dark days of the London Whale incident when they traded down to $31. Since hitting their 52 week high of $51, shares are off slightly to $49 as of this writing. With the London Whale safely behind the bank and mortgage lending seeming to slow this year in comparison to last year, are the shares fairly valued? This article will take a look JPM's estimated fair value based upon its future earnings and dividends.

To do this, we'll use a DCF-type approach that requires some assumptions: 1) discount rate of 10% 2) dividend growth rate of 5% per annum 3) perpetual growth rate of 3% 4) earnings estimates from Yahoo! Finance. I have used what I consider to be reasonable estimates; you may disagree with some or all of my numbers but keep in mind all forecasting is subject to conjecture and risk.

 

 

  

2013

2014

2015

2016

2017

2018

Earnings Forecast

       

Reported earnings per share

  

$5.67

$5.94

$6.36

$6.80

$7.28

x(1+Forecasted earnings growth)

  

4.80%

7.00%

7.00%

7.00%

7.00%

Forecasted earnings per share

 

$5.67

$5.94

$6.36

$6.80

$7.28

$7.79

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$38.40

$42.47

$46.74

$51.34

$56.29

$61.63

Earnings per share

 

$5.67

$5.94

$6.36

$6.80

$7.28

$7.79

-Dividends per share

$1.52

$1.60

$1.68

$1.76

$1.85

$1.94

$2.04

Equity book value at end of year

$38.40

$42.47

$46.74

$51.34

$56.29

$61.63

$67.39

x Equity cost of capital

 

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

 

$4.25

$4.67

$5.13

$5.63

$6.16

$6.74

        

Forecasted EPS

 

$5.67

$5.94

$6.36

$6.80

$7.28

$7.79

-Normal earnings

 

$4.25

$4.67

$5.13

$5.63

$6.16

$6.74

Abnormal earnings

 

$1.42

$1.27

$1.22

$1.17

$1.12

$1.05

x discount factor (10%)

 

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

 

$1.29

$1.05

$0.92

$0.80

$0.69

$0.59

        

Abnormal earnings in year +6

      

$0.59

Assumed long-term growth rate

      

3.00%

Value of terminal year

      

$20.34

        

Estimated share price

       

Sum of discounted AE over horizon

 

$5.35

     

+PV of terminal year AE

 

$11.47

     

PV of all AE

 

$16.82

     

+Current equity book value

 

$38.40

     

Estimated Current share price

 

$55.22

     

Given my assumptions, JPM has an approximate fair value of $55.22 per share right now. Knowing that shares are trading about 13 percent lower than that amount at the time of this writing, they look like a screaming buy. Before you hit the "buy" button though, we need to understand what this number means.

First, it's important to understand what this fair value calculation really means. It implies that discounting JPM's earnings at 10% to compensate for the time value of money and the risk that the company will not achieve those targets still nets a fair value in excess the current trading price. This means that even with a relatively high bar to clear with a 10% discount rate, shares are still pretty cheaply valued. In essence, the fair value price is the price at which the company is still a good buy given your discount rate. As JPM is trading below that amount, it passes that very important test.

Second, the $55.22 is not the forecasted nominal price six years from now. That is the net present value of the company's forecasted earnings at a 10% discount rate. Given the company's current forward PE of 9, shares would be trading at roughly $70 in 2018 if the forward PE remains the same and JPM achieves earnings of $7.79 per share.

Lastly, if you look at the "Dividends per share" line in my model, you'll see that I'm forecasting JPM will pay $10.87 per share in cash dividends from 2013 to 2018. That implies you've got roughly 22% of the current share price headed your way in cash distributions over the next few years given my assumptions about cash dividends. Of course, nobody can forecast what JPM's dividends will look like for the next 6 years, but I believe the company has the available cash to pay virtually any reasonable dividend it pleases. In addition, I believe my dividend assumptions shown here will prove to be conservative, offering additional income and downside protection.

There are risks to my upside forecasts, however, as there are with most of the big banks. First, JPM has the unique risk of a London Whale repeat in the future if the bank has not dealt with its oversight lapses that allowed the event to surface in the first place. Another multi-billion dollar loss will not go over well with investors. Second, the mortgage/refinance boom that occurred through about the end of last year appears to be losing steam and that is cause for concern industry wide. JPM is less concentrated in mortgages than Wells Fargo (NYSE:WFC), for example, but a significant slowdown in mortgage origination activity will be a considerable impediment to earnings growth. Finally, net interest margins have been under pressure for the banking sector since quantitative easing began and so far, they have not begun to significantly rebound. Given the uncertain outlook of interest rates due to the never ending zero interest rate policy environment in which we live, NIM may not rebound for a few years and in fact, may get worse before it gets better.

However, these are not new risks and I have to think management is planning for these. In addition, the dividend that is offered by JPM shares is quite reasonable, cresting a 3% yield at current prices. While there are better income stocks out there, JPM provides a best-of-breed position with growing book value and a very nice dividend to ride out the storm. Given this, I feel the risk for JPM shareholders is to the upside over the medium term as the company enjoys significant cash generation and the best CEO in banking.

Source: JPMorgan: Generous Dividends And Earnings Growth