Amid all the market turmoil, it's often easy to get lost in the headlines such as this. Often, exaggerated and bombastic headlines do well to spook financial markets and average investors. But on Seeking Alpha, I think we aim to be above average investors. We accomplish this by not listening to "the crowd" so to speak, but by thinking rationally before making decisions.
Fortunately for us, the market is not always rational and this presents opportunities for us to make money. One company which I believe the market has irrationally priced is Wells Fargo, (NYSE:WFC). At this point, you might say, "What is he talking about!? The market has recovered nearly all of the Brexit losses, so all the buying opportunities are gone". While the stock market has recovered most of the Brexit losses, we must remember that we are actually talking about a market of stocks.
The stock we will be focusing on is WFC, thought to be one of or if not, the best in breed U.S. bank. WFC was a noteworthy survivor of the great financial crisis, GFC, and came out practically unscathed. WFC has also returned the most capital to shareholders (dividends + buybacks combined since the GFC). Their business is well diversified with an approximate 50% split between net and non interest income.
In the most recent quarter, net income was down slightly from last year due to seasonally higher employee incentive plans and expenses. However, pre-tax pre-provision profit, which strips out onetime and non-recurring items was up 5% year over year. With that in mind, let us explore WFC's valuation and see if it looks fair or not.
To value WFC, I will use a simple and easy to understand discounted earnings per share method, but with a slight twist. I see many authors guessing a discount rate and a growth rate, deriving a fair value and then comparing to the market price. In addition to this methodology, I will fix a required rate of return (this number can be unique to each and every investor), and then solve for the growth rate the market is pricing for.
For the purposes of this article, my required rate of return is 8%, a figure I obtained by analyzing my financial needs and goals. This number will be different for every investor, so should you do your own valuation in the future, I encourage you to come up with your own figure. Notice I left out CAPM, WACC and other formulas I learned from school. While those formulas were convenient to test, the real world is a lot more complex and I believe the required rate of return needs further refinement than a one liner formula.
Next, I started with WFC's estimated earnings per share for 2016 of $4.20 according to the median estimate from Morningstar here.
I won't bore you with the math, (that is unless you want me to, just scream at me in the comments:). If I assume a growth rate of 0% for the next five years and 0% terminal growth, I arrive at ~$52/share fair value estimate (11% above current market prices). Clearly, it is immediately apparent the market must be pricing in a negative growth rate for WFC. To stay true to my previously stated exercise, when I solve for the growth rate that equals WFC's current price, I obtain -1%; yes that's not a typo. The market is effectively pricing a scenario where WFC's earnings will shrink by 1% each year, forever. This is plain silly and not highly likely in my view given WFC's solid business model, sticky customer base, and best in breed asset quality.
I'm thinking the Brexit drama has successfully swooned investors to sell banks on the fears of lower interest rates. I don't think this matters to WFC for two big reasons i) WFC doesn't derive much if any business from the U.K, at least according to this website, and ii) even if lower rates come as a result of Brexit, WFC was already performing well in a low interest environment. Also, half of WFC's income is fee based, so any shortfall on the interest side can be mitigated, (i.e more mortgage refis when rates are low, more wealth management business etc.). Another positive catalyst could be a dividend increase that will probably be declared within the next few weeks. The timing of the 2016 capital plan increase is a bit different than last year, which is why most investors were thrown off by the 0.5c/q increase announced earlier this year, which was part of their 2015 plan.
I present the following growth scenarios:
|Growth for next 5 years||Terminal Growth||Fair Value Estimate Per Share ($)||Current Market Price/Fair Value Estimate|
If we choose Warren Buffett's methodology to only buy stock when the price is trading at a minimum 30% discount to intrinsic value, we would zero in on the 2% five year and terminal growth scenario. In other words, if you believe that WFC can grow earnings at 2% or more forever, then WFC is a solid buy. As a plus you're also being conservative because of the 30% margin of safety for this scenario.
I'd also like to highlight that the figures above are estimates, and valuing stocks is as much an art as it is a science. This is not to say that the numbers aren't accurate, but the takeaway is not that WFC is worth exactly $69/share. The takeaway should be that we have an ~30% margin of safety to WFC's estimated intrinsic value, conservatively calculated, which means it might be currently mispriced by the market.
I hope this article answered some of your questions, or maybe even prompted you to think of new ones. Thank you for reading, (even if you couldn't make it past the title), and do not hold back with your comments and feedback; I enjoy a challenge.
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.