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We've identified First Marblehead (FMD) as one of the most expensive stocks in the financial services sector, based on the implied ROE as suggested by the current price/book valuation of 7.3, the reported smoothed ROE, and the predictability (or lack of) in the earnings stream going forward.

As usual, obtaining excess returns is feasible over a relatively short period of time, but by and large, there are no real barriers to entries in FMD's student loan advisory and securitization business model. And we would expect this to be recognized by market participants over the next few years. And even if we assume above average ROE's through 2008/2009, the stock would still appear to be 30% overvalued under current ideal interest rate conditions (i.e mid-, intermediate and long term rates below 5%) and economic conditions.

Under less favorable conditions (say yield curve shifts upwards 50 basis points), another 20% to 25% could be clipped off the price/book valuation. For now, we assume the degradation in the ROE will be a more gradual process, with the returns falling from the 2004-2006 avaergae of approximately 45% to the mid to high twenties by 2008/2009 (versus 30% for consensus), and the price/book to closer to 3 times book.

How does Wall Street's view differ? To be honest, few are raging bulls (except for Think Equity Partners). But the others (Goldman, FBR, and JPM, Bear Stearns, UBS) though not bullish, can't seem to get a grip around why they the stock is so awfully expensive, and have limped in with neutral or hold ratings, despite expectations of a decline in the ROE to 30% by 2008. But they provide no explanation as to what the current valuation implies in terms of expectations of future earnings, returns on capital, margins, or for that matter the whole business model. This is a flat out sell, the sooner the better.

Trading momentum stocks is one thing, buying on the basis of discounted earnings and cash flow is another. As a veteran watcher of financial stocks, this implosion of this stock is a "When" not "if". For those who may have been burned already by the run up, rest assured that it has less to do with company specifics, and more to do with demand for financial stocks; that firepower seems to show no signs of letting up, so a long short pair trade (say long FRE short FMD) may be the best way to play this thing until technically the stock finally breaks.

Source: The Bear Case on First Marblehead