JPMorgan: The Dual Benefits Of A 'Low' Valuation

| About: JPMorgan Chase (JPM)

Summary

Shares of JPMorgan have regularly traded at a lower comparative valuation.

This may just appear to be a feature of the security, no different than if another stock routinely traded at say 20 times earnings.

However, there are many tangible benefits that occur with a lower starting valuation.

If you were to look up a quote on JPMorgan (NYSE:JPM), you'd see trailing earnings per share near $5.90 or so. For this year, earnings are expected to be down a bit, with something above $6 per share anticipated for 2017. Given a price near $67.50 at the moment, suggests that the security trades with an earnings multiple around 11 or 12 would be fair.

In comparison to a large variety of other firms, this comes in on the lower end of the spectrum. I'd like to outline a couple of reasons why this comparatively "low" valuation can be a benefit to prospective and ongoing shareholders.

Per Share Growth

A lot of investors use average historical earnings multiples as a reference point for valuation. It's not a perfect gauge, but it makes a lot of intuitive sense. If say Coca-Cola (NYSE:KO) has exchanged hands with an average P/E ratio near 19 over the past decade, that could be a reasonable starting point. Expressed differently, you'd have to make a compelling case that suddenly shares ought to trade at a much higher or lower valuation than what has been typical.

Certainly there are exceptions. Yet, in general, using history as a starting point (not an end) is logical enough. The problem, in my view, is when that earnings multiple becomes blindly accepted as absolute.

When you're looking at a security, it's easy to think in terms of starting and ending P/E ratios. For instance, looking at Coca-Cola starting and ending at 19 times earnings, or JPMorgan starting and ending at 11 times earnings. Those seem like the same thing, especially if business performance is the same, but there is an important difference.

If you owned the entire business, what the business result happens to be will be your result as well. However, with public companies, you're not the only shareholder. Instead, shareholder performance can vary widely from business performance depending on if shares are issued or retired. And in this respect, valuation makes a large difference.

I'll give you an example to demonstrate what I mean.

JPMorgan is interesting in that both the dividend payout ratio and the security's valuation are now lower than they were a decade ago. This dual factor leads to the possibility of a more effective share repurchase program (a larger percentage of funds going toward buybacks and a lower price at which to do so).

I'll present two examples: one possible, one hypothetical. We'll start with shares beginning and ending at 11 times earnings. Over the next five years, JPMorgan could utilize perhaps $45 billion in retiring shares. Should company-wide profits grow by say 3% annually, this would mean buying back something on the magnitude of 550 million shares over the next half decade - representing ~15% of the current total.

In this scenario, company-wide profits would grow by 3% per year, but earnings per share would be growing by about 6.4% annually. Now to be sure, you might scale this back depending on your opinion of how effective buybacks will be (and the degree of dilution that will occur), but the point is that per share growth can be meaningfully higher than company-wide growth.

Should shares begin and end at 11 times earnings that would also represent 6.4% annual share price appreciation.

Now, let's think about a hypothetical - shares beginning and ending at 15 times earnings. In practice, this is not possible (you'd have a huge jump in share price appreciation from P/E expansion alone), but it still demonstrates an important point: a lower starting valuation for banks like JPMorgan is fine news for ongoing shareholders.

In this second hypothetical scenario using the same business assumptions, the company could retire perhaps 400 million shares. In turn, business growth would be 3% per year, but per share growth would be about 5.5% per annum. Given the same beginning and ending multiple, capital appreciation would also be 5.5% per year.

Using the same assumptions at 20 times earnings results in capital appreciation of "just" 4.8% per year - the higher the multiple, the less of a benefit for ongoing shareholders and consequently, the lower the multiple, the greater the potential growth benefit.

Now, obviously, this hypothetical example cannot happen in practice, you can't have one world where JPMorgan begins and ends at 11 times earnings and another where the security begins and ends at 15 times earnings. However, the illustration is still quite meaningful.

If you suspect say Coca-Cola and JPMorgan will have the same business results, you're going to prefer the lower valuation of JPMorgan because the per share growth is apt to be faster. This is something that is often overlooked, but the lower the valuation the more effective a share repurchase program can be.

More Compelling Security

In addition to the potential for faster per share growth, a lower valuation also makes a given security more compelling. For one thing, you're starting with a higher dividend. At the current valuation, the $0.48 quarterly dividend represents a starting yield near 2.8%. Should the dividend grow by 5% annually, you might anticipate collecting 16.5% of your starting investment back in the form of cash dividends over the next five years.

On the other hand, in the alternative hypothetical situation of shares starting at 15 times earnings, you might only anticipate collecting 12.5% of your starting investment over the next half decade. The lower the valuation, the higher your starting dividend yield and the larger percentage of dividends you'd expect to collect over time.

Moreover, you also have the potential for P/E expansion in the future. The lower the starting multiple, the greater this possibility is. It's not unimaginable that shares of JPMorgan could trade at say 12 or 13 times earnings. In turn, not only would per share growth be greater from the buyback program, but capital appreciation could also best business results as a consequence of P/E expansion.

The same is possible if you were starting at 15 times earnings, but it gets more difficult the higher you get. It's possible shares will later trade at say 17 times earnings, but moving from 11 to 13 is much easier to envision than 15 to 17. And the "damage" of shares later trading at say 9 or 10 times earnings is naturally reduced if you're already quite close to those marks.

In short, this is a hypothetical demonstration, but it has some important takeaways. If you're looking at two similar securities, it can be instructive to remember some of the benefits associated with a lower starting valuation. Namely, buybacks can be more effective (leading to enhanced per share growth), your dividend income could be improved and the "investment bar" starts at a lower level.

Disclosure: I am/we are long JPM, KO.

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.