With market pricing as a whole dramatically higher than it was just a year ago, it shouldn't surprise anyone that many of my favorite companies are now trading at higher prices, valuations or both. Wells Fargo (NYSE:WFC) is no exception. On May 14th of 2013, I wrote an article entitled "Triple Threat Investing: Wells Fargo." Within this commentary, I indicated that WFC had three main factors working in its favor: a low dividend payout ratio, the ability to grow earnings and a historically diminished price-to-earnings ratio.
At the time of publication, shares of Wells Fargo were trading around $38. Since then, the bid has moved up to about $48 - a 26% increase. So it seems that those wishing to deploy funds today are a bit late to the party (even after factoring in the idea that today's earnings are now about 14% higher). Yet this type of thinking might be making the "woe is me" investing mistake of anchoring. That is, if you turn down the opportunity to evaluate the prospects of WFC today - simply because of its past pricing history - this might be equivalent to refusing to trade 85 cents for a $1 because someone once had the chance to trade 75 cents for that same greenback.
In this light, I thought it might be useful to revisit those favorable "triple threat" attributes and see whether or not they still apply today.
The first investing "threat" was that of a low payout ratio coupled with a reasonable dividend yield. At the time of the last article, WFC earned $3.53 and paid out $1.20 for a 3.2% yield and a 34% payout ratio. Using a few assumptions, I demonstrated that no earnings growth and a 45% payout ratio would equate to a 3.5% nominal gain and dividend growth of about 5.8% over 5 years.
Let's see how this looks today. In the last 12 months, WFC reported earnings of $4.03 and received no objection to its capital plan of paying out $1.40 in the coming year. In turn this equates to a 2.9% yield and a 35% payout ratio. Prior to the recession, we can see that Wells averaged a payout ratio of about 44%:
If you couple this with management's targeted payout ratio of about 50%-65% for both dividends and share repurchases, an aim of paying out 45% in dividends doesn't seem unreasonable (plus, this keeps the examples consistent).
So what might this mean for prospective shareholders? Well, if WFC did not grow earnings at all - still earning $4.03 in 5 years - but increased its payout ratio to 45%, this would equate to a 5.3% annualized constant dividend increase and a roughly 3.1% nominal return. In other words, despite the recent price run-up, this investing benefit remains largely intact.
The second "threat" in the previous article came in the way of earnings growth. At the time, MSN money quoted analysts coming to a 5-year earnings growth rate of 8.3%, while F.A.S.T. Graphs stated 6.3%. By using a conservative 6% growth number - and keeping the payout ratio and P/E constant - this leads to a compounded gain of about 8.9% including dividends.
Today, MSN quotes analysts coming to a 5-year growth rate of 9.2% while F.A.S.T. Graphs indicates 6.9%. Again remaining somewhat conservative, we'll settle on 6% for the next 5 years. In this scenario, earnings grow to $5.39 for a $1.87 dividend and $64 price. Stated differently, these circumstances would equate to an 8.6% annually compounded return - again roughly in line with the expectations of a year ago.
Finally, the third investing "threat" came in the way of a low historical price-to-earnings ratio. At the time of the previous article, WFC was trading at a current P/E of about 10.6 as compared to a "normal" P/E of 15.5. Baking in a bit of conservatism, I went with 14 as a future earnings multiple and no earnings or dividend growth. This equated to an annual price return of 5.4% and a total return of 7.8% per annum, including the dividend.
Today shares of Wells Fargo trade at about 12 times earnings and have effectively the same "normal" P/E ratio:
In turn, if you use the same 14 P/E ratio and no earrings or dividend growth assumptions, this translates to annual price appreciation of about 3.2% and total yearly returns of roughly 5.7%. This time there is a bit of a difference between today and a year ago - which makes sense considering the valuation has increased a bit while the future yardstick remains unchanged.
If you had looked at those past investing "threats" - a low payout ratio, earnings growth or P/E expansion - individually you would find acceptable but not inspiring results. Specifically, you would find potential nominal gains of 3.5%, 8.9% or 7.8% respectively. Yet if you were to combine the three, you would find an average yearly gain of 14.5% - something that perhaps would inspire the potential investor.
In large order, the same conservative estimates hold true for the budding Wells Fargo investment of today. That is, each of the investing "threats" appear relatively average in isolation - a 3.1%, 8.6% or 5.7% nominal yearly expectation for each. Yet collectively, they combine to indicate a 12%-13% annual expectation (and it should be underscored that this is simply an expectation). Perhaps your definition of reasonable returns and mine differ, but personally 12% is nothing to automatically dismiss.
In sum, yes it's true that shares of WFC have marched upwards in the last year from $38 to $48. Furthermore, it's also true that you would have much preferred to buy in at $38 rather than $48. Yet don't allow this singular idea to isolate you from making rational investment decisions moving forward. In fact, I would advocate for one to ignore the past price movement (especially 52-week lows) altogether. Instead, base your decisions on rational expectations moving forward and how the current value proposition supports or thwarts your investing progress.
As a lasting example, consider that Warren Buffett first bought shares of WFC for Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B) in 1989 at a cost of around $7. Had he earmarked this arbitrary price (instead of valuation) as the going rate, he would have stopped purchasing shares, and today Wells Fargo certainly wouldn't be his largest investment holding. You can't invest in the past; the best you can hope for is to rationally evaluate the present.
Disclosure: I am long WFC. 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.