The earnings season will begin in earnest on Friday, with reports due from JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC). This is an interesting time, because we always see a price response to earnings expectations in the lead-up to earnings, with potential for further volatility on earnings release as expectations adjust based on new information available. When there is a price response, there is opportunity to benefit from a price/value arbitrage.
On page 13 of their investor day of 25 February, JPMorgan implies that their stock was attractively valued. At the time, JPMorgan was trading in a $57 to $59 price band. It closed at $59.27 on April 9th. So it is likely that they still view the stock as cheap. Do you?
In this post I express my perception of JPMorgan's Value, and hopefully leave enough information to allow readers to form their own view on value, if they are so inclined.
In my view, a time to nibble is $52. When I say nibble, I mean a small position set at a level which will hurt my ego, but not my portfolio if the stock declines. As it happens, this number is close to JPMorgan's book value of $53.25.
A price of $46 would be an attractive level to buy to allocation. At this price, in my view, current market expectations are fully priced. When I say buy to allocation, I mean buy as much as you think is sensible to own for the long term: for example, if you'd like to own 20 stocks and allocate 5% to each, 5% is what should be allocated to JPMorgan.
In my view, a time to bite lies nearer the tangible book value of $40.81, if the price ever gets there. At this level, the downside is likely limited, and it would make sense to return to allocation, and even consider an over-allocation to JPMorgan.
Believe it or not, this post is a long idea: just not one for now. I would never short JPMorgan: it makes no sense to short a good company merely because it is expensive. When you short, the odds are stacked against you, because downside is unlimited, for there is no limit to how high the price might climb, while upside is limited to the gain made if the price falls to zero. So if you short, you'd better be sure the company shorted will fail!
How safe is JPMorgan
As far is balance sheet is concerned, JPMorgan had a Basel III Tier 1 common ratio of 9.5%, with a 2014 target of 10%. The Basel III Tier 1 capital ratio was 10.2%, with a 2014 target of 11%. The Supplementary Leverage Ratio [SLR] for the Firm & Bank was 4.6%, with a 2014 target of 5%, with a longer-term target of 5.5% for the Firm and 6% for the Bank. So we can see the balance sheet is strong: stronger than required by Basel III norms. But perhaps not strong enough compared with proposed U.S. regulations, which might lead to the SLR for the top eight U.S. banks being raised to 5% for the Holding Company and 6% for Insured Subsidiaries. No major problems here, because JPMorgan has a stated target of 5.5% for the Firm and 6% for the Bank, though I suspect they will raise their targets to be seen as safer than the rest. This will have an impact on forward earnings expectations, as well as on capital requirements: both, in my view, modest.
How do different market participants view JPMorgan?
A couple of years ago, I had written some code to facilitate stock selection. You can view the model output here. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector, and the stock's industry of operation.
JPMorgan scores high on value, regardless of whether viewed relative to the broad market, or JPMorgan's sector or industry of operations. It scores mediocre to low on quality, across the board. The score for growth is weak, no matter whether you look at growth relative to the broad market, or JPMorgan's sector or industry of operations. Momentum is strong when compared with other industry members, and mediocre when compared with the whole market or the sector in which JPMorgan operates.
Source: Alpha Omega Mathematica
AOM Model Recommendation
The stock appeals to value investors seeking to allocate capital to the financial sector, or to the Money Center Bank industry. It is also attractive to momentum investors and investors with no specific stock selection bias, who seek to allocate capital in the Money Center Bank industry. All other stock selection and capital allocation styles are neutral to the stock.
Source: Alpha Omega Mathematica
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 57% and an AOM Hold Recommendation for JPMorgan.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool which uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for JPMorgan:
Why look at JPMorgan now?
Firstly, JPMorgan is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, JPMorgan announced the intention to pay a dividend of $1.60 per share following the Federal Reserve Board's release of the 2014 Comprehensive Capital Analysis and Review results. This provides a dividend yield to 2.7%, which is a premium to the dividend yield offered by the broad market, sector, and industry.
Why not look at JPMorgan now?
Like others in the financial services sector, executive compensation is overly generous at JPMorgan. Banking, at its heart, is a simple business: it connects depositors and lenders to borrowers, and buyers to sellers. Unfortunately, the mid-ground where risks get managed gets overly complicated, at least in part due to a poor incentive structure. But we can't hold this against JPMorgan, since it is an industry-wide problem, and perhaps even a nation-wide problem!
JPMorgan's view of share repurchases takes capital hierarchy and valuation into account: they will buy back first to offset employee issuance, and then consider additional repurchases. And history says that buybacks do not constitute a return of shareholder value at JPMorgan: it is more payment of employee compensation. And depending on the time horizon we look at, such compensation is dilutive to owners to a greater or lesser degree. Over the past five years, JPMorgan has managed to reduce share count, but the decline of 1.68% (not annualized) is nominal. If you believe that this is the new trend, then the annualized decline in shares outstanding rate of 0.3% can be added to the 2.7% dividend yield to give you an estimate of total shareholder value returned.
Of course, looking at things over a ten-year period, we see a fairly sizeable rise in average annual diluted shares outstanding. A rise in annual average diluted shares outstanding of 33.81% in total over ten years represents an annualized rate of dilution of 2.96%. And so, if you expect this to continue, be wary, because the dividend yield of 2.7% which you receive is more than fully offset by the dilution you suffer. On my part, I will nod to the crisis years and say that I do not expect it to recur, but nor shall I expect any return on value via buybacks net of dilution.
Beta, co-efficient of determination and alpha intercept considerations
The Value Line report, which you can download here, reports a beta of 1.30 for JPMorgan. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.42, and I adjust it to 1.24 on account of the beta's tendency to converge towards one. This beta of over one can be constructive in a rising market and destructive in declines, thus, it cannot be said to possess defensive characteristics.
The coefficient of determination for JPMorgan is 57.66%. This suggests that 57.66% of the price movement in JPMorgan is explained by movements in the market: the residual price movement is based on company-specific factors. This coefficient of determination suggests that the market-related risks are average. And because 42.34% of the price movement represents company-specific risks, these risks should be diversified.
Cyclicality and JPMorgan
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, no discernible pattern is evident for stocks in the financial services sector. In my view, the late-cycle conditions are associated with a flattening of the yield curve, and even an inversion towards the end of the late-cycle. If I am right, this is negative for JPMorgan investors, but it is a positive for potential investors in JPMorgan, because late in the late-cycle and early in the recession is a time when a buy opportunity often, but not always, arises. And coming on the heels of a recession is the early-cycle: a period when the financial services sector tends to outperform very substantially.
You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance, today, I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, if Europe, other developed markets, or emerging markets shift into early-cycle conditions, this is a time when the financial services sector typically outperforms, and U.S. companies in the financial services sector could well outperform too.
Analyst price expectations
Recently, JPMorgan traded at $59.27. From Yahoo Finance, we know that thirty analysts expect an average price target of $66.40 (median $67.00), with a high target of $75 and a low target of $55. This is a wide dispersion in expectations, which suggests risks are high. It is early in the year. So far, the bulls looking for $75 trail the bears looking for $55.
We might believe that JPMorgan is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe in the analysis of the perception of different market participants. We also know that JPMorgan is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a standalone basis and regardless of broad market valuations.
Mathematically, the worth of JPMorgan is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.24, a long-term risk-free rate of 4.50%, and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk-Free Rate plus Beta Multiplied by Market Return less Risk-Free Rate. Thus, for JPMorgan, we should be targeting a long-term return of 11.63%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time.
Twenty-seven analysts included on Reuters data estimate average earnings of $5.87 (High: $6.53, Low: 5.35) for the year ended December 14, while twenty-nine analysts estimate that it will rise to an average of $6.34 (High: $6.95, Low: 5.56) for the year ending December 15. Three analysts assess long-term growth rates at 5.81% on average, with a high estimate of 8% and a low estimate of 3%.
This chart displays normalized diluted EPS on a trailing twelve-month basis for the past five years and estimates for the current and coming three fiscal years.
I am comfortable with $4.85 (about 3 times the dividend of $1.60) as a fair representation of sustainable earnings, and $5.75 is a fair estimate of 2014 earnings.
I expect JPMorgan will pay out approximately 35% of earnings via a dividend. An additional payout of 17.50% will go towards buybacks to limit the dilutive impact of share issuance to employees, leaving 47.50% for reinvestment in growth. This 47.50% of retained profit re-invested at a 15% return on equity indicates a long-term potential growth rate of 7.1% (47.50% * 15% = 7.1%). This return on incremental equity is not unreasonable to expect, and it is consistent with the return on tangible common equity targets of 15% to 16% presented by JPMorgan at its Investor Day meeting.
If we use a very long-term growth expectation of 8.52%, JPMorgan is worth $59.27. JPMorgan Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 108.52% * $4.85 * 35% / (11.63%-8.52%) = $59.27. At this price, it is likely that an investor with a return expectation of 11.63% will be satisfied.
The growth estimate implied by the current market price of 8.52% is too high. Alpha is the difference between actual returns and the risk-adjusted return expectation. If JPMorgan grows at a long-term rate of 7.1%, in line with my estimate, we have negative growth alpha of 1.42%. And an investor buying at present levels can expect a long-term return of 10.21%.
A better buy price lies nearer the tangible book value of $40.81, if the price ever gets there. This represents good value, assuming a long-term growth rate of 7.1%, sustainable earnings of $4.85, payout ratio of 35%, beta of 1.24, and an investor target return of 11.63% (107.1% * $4.85 * 35% / (11.63%-7.1%)=$40.13). This is a time to bite.
Now, if analyst expectations are correct, and earnings grow from $5.33 at end 2013 to $7.66 by end 2014, we have a four-year growth rate of 9.49%. Assuming that growth reverts to long-term potential growth rates of 7.1% in the fifth year, we have a composite very long-term (50 years, 4 at 9.49% growth and 46 at 7.1% growth) growth rate of 7.3%. This implies a value target of $46.22 (107.3% * $5.33 * 35% / (11.63%-7.3%) = $46.22). This is a time to buy to allocation.
A more optimistic person might consider $5.33 a fair reflection of sustainable earnings. They might also consider a long-term growth rate of near 7.6%, based on 47.50% of earnings being re-invested at a 16% return on equity, which is at the top of the range of JPMorgan's TTC return on tangible common equity targets. And they might accept analyst estimates of a 9.49% four-year growth rate. A composite very long-term growth (50 years, with 4 at 9.49% and 46 at 7.6%) rate of 7.75% would result. Such a person might consider buying at $51.81, which is close to the $53.25 book value level. This represents good value, assuming a composite very long-term growth rate of 7.75%, sustainable earnings of $5.33, payout ratio of 35%, beta of 1.24, and an investor target return of 11.63% (107.75% * $5.33 * 35% / (11.63%-7.75%)=$51.81). This is a time to nibble.
But at $59.27, in my view, JPMorgan is currently priced for the optimist and priced for perfection.
The post is done - this is an explanatory note
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk-free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium. You will also need to think about how the risk-free rates will impact long-term growth. If you alter the adjusted payout assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted payout ratios, risk-free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas, which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is long-term return expectation minus long-term growth rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want, by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast-growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very long term, the growth risk premium has tended toward 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings
3. When you look at long-term growth rates, remember it is not the next year's growth or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rates for some years, reversion to market growth rates, and finally, a terminal growth rate. The terminal growth rate used by many is the risk-free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I, as an investor, have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in line with market growth expectations for the following 45 years. What this signals is that I'm willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On Excel, you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so, a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher-than-industry leverage implies higher financial risk, and this implies a higher beta and a higher market return expectation. If you see a low beta with higher-than-industry leverage, you may want to compute a bottom-up beta for the company, instead of one generated using regression analysis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.