Wells Fargo (NYSE:WFC) shares were perhaps the least damaged among the big banks from the effects of the financial crisis. It is widely regarded as the strongest banking franchise overall, perhaps except for JPMorgan (NYSE:JPM), but certainly in retail banking and mortgage origination. Given that Wells' shares didn't suffer the same way other banks' shares did, is there still value to be had? This article will take a look WFC'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 7% 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.
Reported earnings per share
x(1+Forecasted earnings growth)
Forecasted earnings per share
Equity Book Value Forecasts
Equity book value at beginning of year
Earnings per share
-Dividends per share
Equity book value at end of year
x Equity cost of capital
x discount factor (10%)
Abnormal earnings disc to present
Abnormal earnings in year +6
Assumed long-term growth rate
Value of terminal year
Estimated share price
Sum of discounted AE over horizon
+PV of terminal year AE
PV of all AE
+Current equity book value
Estimated Current share price
Given my assumptions, WFC has an approximate fair value of $42.46 per share right now. Knowing that shares are trading about 12 percent lower than that amount at the time of this writing, shares look like a nice 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 WFC'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 WFC is trading below that amount, it passes that very important test with some room to spare.
Second, the $42.46 is not the forecasted nominal price six years from now. Rather, it represents the net present value of the company's forecasted earnings at a 10% discount rate. Given the company's current forward PE of 9.7, shares would be trading at roughly $52 in 2018 if the forward PE remains the same and WFC achieves earnings of $5.32 per share.
Lastly, if you look at the "Dividends per share" line in my model, you'll see that I'm forecasting WFC will pay $9.17 per share in cash dividends from 2013 to 2018. That implies you've got a robust 24% of the current share price coming your way in cash distributions over the next few years given my estimates. Of course, nobody can forecast what WFC'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. Wells has the ability to literally double the dividend if it pleases. While I think that will be a few years off, the point is that my dividend forecast shown here is probably too conservative, offering additional upside to the share.
There are risks to my upside forecasts, however, as there are with most of the big banks. Wells is an extremely well run bank, so well run in fact that Warren Buffett has a famously enormous position in the company. As a result of such stellar management performance, the risks of loss with WFC are perhaps lower than some of the bank's too-big-to-fail brethren. However, with WFC so concentrated in mortgage origination, with its completely dominant market share position, the widely accepted coming slowdown in origination activity could be a significant impediment to earnings growth. I have full confidence that the Board knows this better than anyone and are planning for just such an event, but it is a risk worth noting given WFC's reliance upon mortgage origination to generate revenue. 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 they get better. Again, Wells is better than most at managing this phenomenon but some things are out of management control.
These are not new risks for the most part and I have to think management is planning for these. In addition, the dividend that is offered by WFC shares is quite reasonable, topping a 3% yield at current prices. While there are perhaps better pure income stocks out there, Wells Fargo provides a best-of-breed position in the enormous mortgage origination market with growing book value and a very nice dividend to ride out any storms that may surface. Given this, I feel the risk for WFC shareholders is to the upside over the medium term as the company enjoys significant cash generation and tremendous management from the top. In addition, Wells can easily raise its dividend at double digit rates every year for the foreseeable future if management chooses, offering an enormous amount of cash payouts to patient holders of the stock.