Wells Fargo: Still A Buy After Doubling?

Jul.28.14 | About: Wells Fargo (WFC)

Summary

Wells Fargo shares have doubled in the past two years.

The company's decent dividend has room to expand through increased earnings and a higher payout ratio.

What do total returns look like over the short and medium terms?

Wells Fargo (NYSE:WFC) shares have been a slow and steady winner for investors for the past couple of years, doubling since the end of 2012. The company is known as the "traditional" bank among the too-big-to-fail behemoths since WFC engages in what one would consider old fashioned banking activities of taking in deposits and lending them out (imagine that). Investors have been rewarded with a decent dividend and strong capital appreciation but given that the stock has moved so much in just the past couple of years, has WFC's $270 billion market cap gotten ahead of itself?

To assign a value to shares we'll use a DCF-type model in order to show what WFC's business may be worth given future expectations. I'll use earnings estimates from Yahoo! Finance and some estimates of my own including a steady payout ratio of 34%, a discount rate of 8.5% and a perpetual growth rate of 3%. These estimates are what I would consider to be rather conservative, particularly the payout ratio, so there may be moderate upside to the value we assign here.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$3.89

$4.11

$4.27

$4.69

$5.14

$5.64

x(1+Forecasted earnings growth)

5.70%

3.90%

9.70%

9.70%

9.70%

9.70%

=Forecasted earnings per share

$4.11

$4.27

$4.69

$5.14

$5.64

$6.19

Equity Book Value Forecasts

Equity book value at beginning of year

$31.21

$33.92

$36.74

$39.83

$43.23

$46.95

Earnings per share

$4.11

$4.27

$4.69

$5.14

$5.64

$6.19

-Dividends per share

$1.40

$1.45

$1.59

$1.75

$1.92

$2.10

=Equity book value at EOY

$31.21

$33.92

$36.74

$39.83

$43.23

$46.95

$51.03

Abnormal earnings

Equity book value at begin of year

$31.21

$33.92

$36.74

$39.83

$43.23

$46.95

x Equity cost of capital

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

8.50%

=Normal earnings

$2.65

$2.88

$3.12

$3.39

$3.67

$3.99

Forecasted EPS

$4.11

$4.27

$4.69

$5.14

$5.64

$6.19

-Normal earnings

$2.65

$2.88

$3.12

$3.39

$3.67

$3.99

=Abnormal earnings

$1.46

$1.39

$1.56

$1.76

$1.97

$2.20

Valuation

Future abnormal earnings

$1.46

$1.39

$1.56

$1.76

$1.97

$2.20

x discount factor(0.085)

0.922

0.849

0.783

0.722

0.665

0.613

=Abnormal earnings disc to present

$1.34

$1.18

$1.22

$1.27

$1.31

$1.35

Abnormal earnings in year +6

$2.20

Assumed long-term growth rate

3.00%

Value of terminal year

$39.93

Estimated share price

Sum of discounted AE over horizon

$6.32

+PV of terminal year AE

$24.47

=PV of all AE

$30.80

+Current equity book value

$31.21

=Estimated current share price

$62.01

Click to enlarge

As you can see the model produces a price of $62, or more than $10 higher than Friday's close of $51.60. That is a significant discrepancy so why should we believe the model? Remembering that the model is an estimate we can still use it to determine if WFC shares are a good buy right now.

To begin, we'll first need to understand exactly what the model is saying. The $62 is the computed fair value of WFC shares right now given the inputs you see in the model. Importantly, it is not a target price. Rather the model is saying that buying WFC is a good idea right now at any price lower than $62. Since we are substantially below that number right now, we can assume WFC shares are cheap on a relative basis.

One thing that may be inflating the fair value of WFC in my model is the relatively low discount rate I chose of 8.5%. However, I chose this for good reason. Interest rates are still very low so the risk free rate is quite low and in addition to that, WFC is one of the safest, most stable large stocks available in this humble author's opinion so a large equity risk premium is unjustified. I chose a 6% premium over the 10 Year Treasury rate and arrived at 8.5%. Increasing the risk premium would decrease the computed fair value of shares but in the case of WFC, I don't think that's warranted.

So what does WFC have going for it? First, it is the premier franchise in banking. As I said in the opening, WFC is a traditional bank, it just happens to be huge. WFC doesn't get wrapped up in the kinds of things that get it sued constantly like a certain Charlotte-based bank (BAC). And while anyone that reads my articles knows I like Bank of America, it is for completely different reasons. WFC is very well-managed and you can have confidence that it won't be steered into risky products that will cause it to be sued on a massive scale or bailed out anytime soon.

In addition to that, WFC makes capital returns a priority. I mentioned the dividend earlier and while the 2.6% yield is decent, it's very safe. WFC's current payout ratio of 34% is more than sustainable, it's even a bit lower than what the company could handle. WFC could easily raise its payout incrementally to 38% to 40% with little effort. This is good news for long-term shareholders as it means that if WFC were to do that and hit the earnings targets shown above, 2019's dividend could approach $2.50 per share, or nearly double the current per share payout. That is tremendous dividend growth given WFC's steady-as-she-goes nature and even if the payout isn't $2.50 in 2019, it will certainly be over $2.00. WFC is a classic case of letting dividends compound for years to come so that one's yield on today's cost could be in the 5% to 6% range in the not-too-distant future.

Finally, WFC is cheap at only 12 times forward earnings and in addition to that, the earnings growth rates are very manageable. We are talking about mid- to high-single digit growth rates in earnings and given that WFC is one of the few large banks to actually experience growing revenue, I think the targets are quite achievable. This could be another source of low to moderate upside in the fair value target.

Overall, WFC is the premier franchise in the traditional banking space. WFC is extremely well managed and provides investors with the chance to gain exposure to banking without having to hand over enormous amounts of shareholder capital to the government and scores of attorneys. The dividend will continue to grow and there is upside to the payout ratio, further boosting potential returns. I think we'll see WFC drift higher towards $60 over the next twelve months in much the same way it has over the past year, providing investors with a slow and steady approach to profiting from the banking space.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.