22% Plus Upside For Wells Fargo

| About: Wells Fargo (WFC)

Summary

Growth: Topline Revenue Growth has been nonexistent. Overall Net Income Growth has been stabilizing.

Quality: Wells Fargo is consistently well-run compared to its leading competitors and industry.

Valuation: Weighted Fair Value Estimate of $58.70 implying a 22% Plus Upside Potential.

Wells Fargo & Company (NYSE:WFC) is a solid buy with 22% plus upside potential. It is a bank holding company. The company is a financial services company, which offers banking, insurance, trust and investments, mortgage banking, investment banking, retail banking, brokerage, and consumer and commercial finance. The bank has three operating segments: Community Banking, Wholesale Banking, and Wealth and Investment Management. It operates through over 8,700 locations and approximately 13,000 automated teller machines.

There are 3 Pillars that determine a company's outlook are its: 1) Growth, 2) Quality and 3) Valuations. Let's exam them to understand why Wells Fargo is a solid buy.

Growth

Graph created by me using data from AAII Stock Investor Pro.

Sales

Average Sales Growth for the periods in the study was -1.53%. However, since 2014 Sales Growth has been positive and average 2.22% annual growth. Due to the recent financial crisis, the flat revenue growth is acceptable give the recent economic downturn.

Table created by me using data from AAII Stock Investor Pro.

Net Income

Average Net Income Growth for the periods in the study was 15.96%. This is a little miss leading because since 2014 average Net Income Growth was 0.37%. Most of the growth in this area happened over four years ago. Recent growth has been flat.

Table created by me using data from AAII Stock Investor Pro.

Free Cash Flow

Average Free Cash Flow growth for the periods in the study was 28.39%. This is a little miss leading because since 2014 average Free Cash Flow growth was -22.17%. The average statistic is skewed given an 328.39% change in 2012. Except for 2012, Free Cash Flow growth has largely been negative except for the current trailing twelve months.

Table created by me using data from AAII Stock Investor Pro.

Quality

Key Statistics

Understanding a bank's financial statement is different from your standard income, balance sheet and cash flow statements. Let's look at eight essential bank metrics to help us understand how Wells Fargo stacks up.

  1. Loans to Total Assets = $965,579 / $1,849,182 = 52.22%

The greater the Loans to Total Assets number is the more traditional of a bank it is. This is consistent with Wells Fargo strategy. In addition to traditional bank lending, the company also generates a large percentage of its business from Wholesale Banking and Wealth & Investment Management.

  1. Total Deposits to Total Liabilities = $1,241,490 / $1,651,686 = 75.17%

If the bank has a lot of liabilities to attract more deposits, then this can lead to risky lending behavior. A high ratio means that the bank might not have enough liquidity to cover any unforeseen fund requirements. A low ratio indicates the bank may not be earning as much as they could be.

  1. Equity to Total Assets Ratio = 10.7%

A bank's Equity/Total Assets Ratio is a key indicator of solvency and financial strength. The higher the equity to asset ratio, the less leveraged the company is. This means that a larger percentage of its assets are owned by the company and its investors.

  1. Net Interest Margin = Net Interest Income / Total Assets = $45,982 / $1,849,182 = 2.49%

Net Interest Income measures the profit a bank makes by borrowing at one rate and lending at another higher rate. This ratio is similar to the gross margin (or gross profit margin) of non-financial companies. Net Interest Margin below 3% (not good) and above 4% (quite good). Given the meltdown from the last financial crisis, the 2.49% is decent.

  1. Noninterest Income = $40,992

Noninterest Income is the money the banks makes from everything else. Noninterest income is revenue derived primarily from fees including deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly account service charges, inactivity fees, check and deposit slip fees.

  1. Efficiency Ratio = Noninterest Expense / Net Revenue = $50,495 / $86,974 = 58.06%

A bank efficiency ratio is a measure of its overhead as a percentage of its revenue. The ratio is a quick and easy measure of a bank's ability to turn resources into revenue. The lower the ratio, the better (50% is generally regarded as the maximum optimal ratio). An increase in the efficiency ratio indicates either increasing costs or decreasing revenues. Efficiency Ratio below 50% ( good ) and above 70% (could be a cause for concern). Wells Fargo's Efficiency Ratio is pretty good at 58.06%.

  1. Charge-off Ratio = Net Chargeoffs / Gross Loans = $12,496 / $935,512.5 = 1.34%

The charge-off ratio is the ratio of the net charge-offs to the average outstanding loans. The net charge-offs of an accounting period are equal to the loans charged off during the period minus recoveries. These are partial or full payments from customers on loans that the bank had charged off in previous accounting periods. Given the recent financial crisis, 1.34% is a good number.

  1. Loan Loss Allowance to Loans Ratio = Allowance for Loan Losses / Total Loans Outstanding = $11,621 / $965,579 = 1.20%

The purpose of the ratio is to help financial institutions and analysts determine if the bank or credit union in question has adequate Allowance for Loan and- Lease Losses (ALLL) levels. While differences across banks in loan portfolio composition and in risk management practices make it difficult to determine a standard for this ratio, comparing the ALLL to Total Loans across time for an individual bank to look for trends can be beneficial. This Loan Loss Allowance to Loans Ratio of 1.20% looks okay.

Profits

Economic Profit

As we have seen, Wells Fargo has been able to generate positive Net Income throughout the period. However, Net Income Measures Accounting Profit only. A better standard is Economic Profit. I calculate Economic Profit as follows:

Economic Profit = Net Income - Equity * Required Rate of Return on Equity

This equation takes Net Income, which already factors in debt cost, and subtracts the equity costs to determine Economic Profit.

Table created by me using data from AAII Stock Investor Pro.

Average Economic Profit for the periods in the study was $1,227 million. Since 2014, Economic Profit has averaged $2,298 million.

Risks

Financial Leverage Comparison

Graph created by me using data from AAII Stock Investor Pro.

Debt to Total Assets ratio is an indicator of financial leverage. This measures the percentage of total assets that were financed by creditors, liabilities, debt. For the time period of the study, Wells Fargo's Debt to Total Assets was similar to Bank of America (NYSE:BAC), Citigroup (NYSE:C) and JPMorgan Chase (NYSE:JPM). However, its Debt to Total Assets was significantly higher than its industry average.

Times Interest Earned Comparison

Table created by me using data from AAII Stock Investor Pro.

Times Interest Earned (or interest coverage ratio) is a measure of a company's ability to honor its debt payments. A higher number is better. Wells Fargo averaged a Times Interest Earned ratio of 6.70 for the study period. This indicated its financial strength compared to its major competitors and industry in general.

Returns

ROE Comparison

Table created by me using data from AAII Stock Investor Pro.

ROE measures the efficiency with which a company uses shareholders' equity and is a great overall measure on returns on capital. (Note: A flaw in using ROE is a company can take on a lot of debt and boost ROE without becoming more profitable therefore you should look at Return on Invested Capital).

ROE = net income / shareholder's equity

Wells Fargo's average ROE for the study was 12.53%. This was the highest average among compared competitors and average industry statistics.

ROC Comparison

Table created by me using data from AAII Stock Investor Pro.

ROC = EBIT / (Current Assets - Current Liabilities + Net Fixed Assets)

EBIT is used because companies operate with different levels of debt and differing tax rates. By using EBIT, you can compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.

Net working capital plus net fixed assets (or tangible capital employed) was used in place of total assets (used in ROA) or equity (used in a ROE). This figures out how much capital is actually needed to conduct the company's business. Net working capital is used because a company has to fund receivables and inventory. Net fixed asset is used because a company has to fund the purchase of fixed assets to conduct business (i.e. real estate, plant and equipment).

Again, Wells Fargo outshined BAC and JPM with its Return on Capital (there was no data for Citigroup or the Industry).

Owner's Earnings Yield

Owner's Earnings Yield measures the return by taking the sum of Net Income + Depreciation & Amortization - Average 3 Year Capital Expenditures and dividing by its market capitalization. I modeled this after the famous Warren Buffet. This metric allows you to see what an owner is really making.

Table created by me using data from AAII Stock Investor Pro.

Wells Fargo had a respectable 11% Owner's Earnings Yield.

Valuations

Relative Valuations

Price to Earnings

PE Multiple for the Industry is 14.7. If we multiply it with Earnings (average of the TTM Earning of $4.12 and 1-Year Forward Earnings Estimate of $4.39) we come up with a Fair Value Estimate of $62.55.

Price to Book

PB Multiple for the Industry is 1.1. If we multiply it with Book Value per Share of $34.17 we come up with a Fair Value Estimate of $37.58.

Combined PE and PB Fair Values

Combine Fair Value Estimate = ($62.55 * $37.58) ^ 0.5 = $48.48

Discounted Cash Flow (DCF)

Assuming: 1) a 10-Year Average Growth Rate of 5.0%, 2) a 4.0% Terminal Growth Rate and 3) a Discount Rate of 10.0%, my DCF Model projects the Fair Value per Share of $61.57.

Please see this link for a copy of the DCF Model:

Dividend Model

Wells Fargo Dividend Growth and Yield Summary:

Table created by me using data from Yahoo Finance.

Click to enlarge

Dividend Valuation Model created by me using data from Stock Investor Pro and Yahoo Finance.

Morningstar

Morningstar Fair Value Estimate for Wells Fargo is $61.00.

Economic Moat is Wide. Stewardship is Exemplary. Growth is rated a C. Profitability is rated a C. Finally, Morningstar Credit Rating is an A.

Value Line

Value Line's Target Price Range is $60.00 to $85.00. Appreciation potential is 20% to 70%. Annual Total Return Projection is 8% to 16%.

Table created by me using data from Stock Investor Pro and Yahoo Finance.

Conclusion

Margin of Safety

Benjamin Graham and David Dodd (founders of value investing) coined the term Margin of Safety in their seminal 1934 book, Security Analysis. Margin of safety is the difference between the intrinsic value of a stock and its market price. Given the closing price of $47.81 and the Weighted Fair Value Estimate of $58.70, the Margin of Safety is 18.55% (or ($58.70 - $47.81) / $58.70).

Profit Potential

With the current Dividend Yield of 3.15% and an appreciation potential of 22%, Wells Fargo is a solid BUY Recommendation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.