Wells Fargo: A Good Business Model, But We Now Need The Cash

| About: Wells Fargo (WFC)

Summary

While earnings for Wells Fargo have been increasing overall, free cash flow has lagged behind.

The bank does not appear to be undervalued at the current price.

I am expecting significant growth in free cash flow to justify further price growth.

Throughout my analysis of Wells Fargo (NYSE:WFC), I have continuously been optimistic about the bank's prospects and indeed have written articles expressing said sentiment. However, I would be lying if I said that a stall in price growth does not offer sufficient reason to reassess my prior assumptions at this point.

I have held a position in Wells Fargo for nearly three years at this point, and the major competitive advantage that the bank has held has been the firm's commercially-oriented model, being the bank of choice among small and large businesses as well as developing a strong investment banking arm in order to mitigate the effects of interest rate risk across its other businesses.

With all this being said, much of my analysis has been on earnings, which I have projected will rise on the basis of a strong banking model. However, the primary purpose of any financial institution is to bring in more money than it gives out. This has to eventually translate into cash generation - otherwise, earnings are simply academic in the long term. In this context, comparing earnings per share (diluted) with free cash flow per share over a five-year period reveals an interesting insight:

We see that while earnings per share growth has leveled off since 2014, the bank has seen an overall increase in this metric. However, we see that growth in free cash flow per share has been very volatile and is touching lows not seen since 2012.

The banking sector in general has had a tough time of it lately. While Wells Fargo has been building a diversified business model, generating hard cash flow has been difficult in a low interest rate environment. Moreover, rising interest rates in the United States has meant that economic growth has adjusted downwards as a result. In this sense, growth in free cash flow has stalled.

So, is the current price of $48 a bargain? Not necessarily. When we look at price to free cash flow, we see that this metric is near its highs in the context of a five-year period, meaning that price is not significantly undervalued relative to cash flow:

Moreover, if we hypothetically assume that Wells Fargo were to be valued on the basis of growth in both dividends and free cash flow per annum, it becomes clear that high future rates of growth in free cash flow are necessary to justify upside. Assuming a 10% discount rate (or assuming a relative expected rate of growth in the S&P 500 over the next five years to compensate for a prior stalling of market growth since 2015), we yield the following:

10% growth in dividends and free cash flow

Dividend Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 10% dividend growth 1.50 1.65 1.82 2.00 2.20
10% discount rate 1.40 1.44 1.48 1.52 1.57
Free Cash Flow Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 10% Free Cash Flow Growth 3.39 3.72 4.10 4.51 4.96
10% discount rate 3.08 3.08 3.08 3.08 3.08
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Terminal Price to FCF Ratio (which is the current one) 14.25
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 43.86
Present Value of Dividends Per Share Through to Year 5 7.413568596
Target Price in Year 5 51.2776595051
Upside from price of $48.24 6.30%
5-Year Annualised Rate of Return 1.26%
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20% growth in dividends and free cash flow

Dividend Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 20% dividend growth 1.50 1.80 2.16 2.59 3.11
10% discount rate 1.40 1.57 1.76 1.98 2.22
Free Cash Flow Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected 20% Free Cash Flow Growth 3.39 4.06 4.88 5.85 7.02
10% discount rate 3.08 3.36 3.66 4.00 4.36
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Terminal Price to FCF Ratio (which is the current one)

14.25
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 62.12
Present Value of Dividends Per Share Through to Year 5 8.9323588861
Target Price in Year 5 71.056926135
Upside from price of $48.24 47.30%
5-Year Annualised Rate of Return 9.46%
Click to enlarge

We see that for Wells Fargo to appreciate significantly, investors would be looking for an average 20% growth in dividends and free cash flow. Failing this, then we could see a situation where Wells Fargo becomes more income rather than growth-oriented.

To conclude, I remain long on Wells Fargo and continue to have faith in its business model. However, I would expect to see a significant upturn in free cash flow generation in the coming year to reaffirm my sentiment. I remain patient, but Wells Fargo has to start producing cash eventually.

Disclosure: I am/we are 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.