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Interactive Brokers (NASDAQ:IBKR) is a company made up of two constituent parts: brokerage and market making. Market making was the original business, and they used its technology to start selling brokerage services. And what a technology suite it is. Interactive Brokers has been consistently superior to other brokers, as evidenced by its market share gains and how consistently it wins awards.

I should disclose that I personally use IBKR's brokerage for my investment account, and anecdotally I find it both superior and more convenient than the other options available. Other investors must feel the same way as they have been consistently growing their customer base. They disclose these metrics monthly. In their most recent report, they noted customer accounts were up 12% year over year, trades up 17%, and margin loans up 25%.

IBKR has expanded dramatically in international markets, and over 55% of their accounts are outside the US. Interactive Broker's competitive advantage is even greater outside the US, where financial markets are less competitive and brokerage rates are higher. This diversifies the companies revenue across different equity markets and currencies.

The market making business is less profitable than brokerage and not growing. This business has a huge amount of capital, which provides a downside floor on its valuation. The two businesses are run and capitalized separately.

IBKR owns approximately 11.9% of the operating entities carrying on the business, which implies a $6.2 billion valuation for the business at its recent price of $15.58. Book value of the combined business is $4.83 billion, which provides a floor on the stock. The business has never traded below book value, putting a $12.14 floor on the stock.

The potential outcomes for IBKR are extremely asymmetrical. The upside potential in the business is significant. Valuing the market maker at its book value gives $2.7 billion, and it is possible market conditions for this business improve, giving it an adequate return and increasing its value above book. I'm ascribing no value to this possibility, but assigning the option value in operational improvements to the "margin of safety" bucket.

The brokerage business also has a significant amount of excess capital, approximately $2.0 billion. This provides significant downside protection for the brokerage business, but its value is really determined by its earnings. The brokerage segment earned $111 million pre-tax last year. Annualizing this and applying a 15x P/E to the brokerage business yields a valuation of $6.7 billion for the brokerage business.

Fifteen times earnings is very reasonable for a brokerage business where the last quarter earnings were >30% growth year over year, and margins are expanding. Their growth in customers is leveraging their fixed costs, so earnings growth is outpacing revenue growth. This provides them a virtuous circle on pricing, as they can under price their competitors and still increase their earnings. A 30% growth rate and a 15X P/E gives a 0.5 PEG ratio, which is another data point on the valuation being reasonable.

The combined value of the business under these valuations is $9.4 billion, or a per share value of $23.55. This upside valuation is asymmetrical compared to the downside protection provided by book value, and there are also significant potential catalysts.

IBKR has done two special dividends in the last three years, and there was a discussion about that possibility on the last conference call. Those announcements have moved the stock in the past, and would do so again. There were also discussions about the timeframe of a potential windup of the market maker business, and that capital would be available for a special dividend in the event of a windup.

Another potential catalyst is higher interest rates, which would improve their earnings on customer credit balances and on cash collateral they hold for stock lending. That being said, if ZIRP continues, the flow of funds into equities should continue to drive trading volumes, giving them balanced improvements in any macro environment.

In conclusion, IBKR is a long with asymmetrical upside, significant continuing growth in a business with a competitive advantage, and protected downside. It is a business with a franchise that follows the first rule of investing "don't lose money" due to the tangible downside protection.

Source: Interactive Brokers - Asymmetric Upside and Growth in a Franchise Business