With financials rallying, my bullish calls are starting to net followers considerable wealth. One stock that investors are overly discounting is Charles Schwab (SCHW). In this article, I will run you through my DCF model on the company and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to TD Ameritrade (AMTD) and JPMorgan (JPM). While I find Schwab significantly undervalued, JPMorgan has an even more attractive "long case" going for it.
First, let's begin with an assumption about the top-line. Schwab finished FY 2011 with $4.7B in revenue, which represented a 10.4% gain off of the preceding year. I model growth trending from 12% to 3% over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model SG&A eating 60.5% of revenue versus 3.3% for capex. Taxes are estimated at 38% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $19.03, implying 33.5% upside. The market seems to be factoring in a WACC of 14% which is much too high for a company that has plenty of cash at hand. This just shows you the extent to which investors have irrationally blown up risk for financials.
All of this falls within the context of encouraging momentum:
Taking a look at 2011, you can see some of the metrics. We continue to grow whether it was brokerage accounts, new assets. The core up, a little bit over $80 billion, 145 total, but that does include a large clearing amount, which we always like to break out for you, because the revenue on it is much smaller.
Our client asset is approaching $1.7 billion at the end of the year. I think the last one is the one that we are most pleased about and that is hitting a record-client promoter score in our retail business, which, of course, is around 2/3 of the firm's revenue and 2/3 of the firm's earnings, hitting a record in December of 2011.
From a multiples perspective, Schwab is reasonable. It trades at a respective 20.1x and 16.8x past and forward earnings versus 17.2x and 14.6x for TD Ameritrade and 9.9x and 8.1x for JPMorgan. Assuming the multiple falls to 18x and management produces a conservative 2013 EPS of $1.04, the stock would hit $18.72 - close to my DCF result.
Consensus estimates for TD Ameritrade's EPS forecast that it will grow by 1.8% to $1.13 in 2012 and then by 18.6% and 22.4% in the following two years. Assuming a multiple of 18x and a conservative 2013 EPS of $1.31, the stock would hit $23.58, implying 21.2% upside. In my view, this securities broker is thus less attractive than its competitor. The Street nevertheless views the companies as equally attractive.
Consensus estimates for investment banking giant JPMorgan's EPS forecast that it will grow by 6.9% to $4.79 in 2012 and then by 15.2% and 9.8% in the following two years. Assuming a multiple of just 12x and a conservative 2013 EPS of $5.45, the stock would explode skyward by nearly 50%. Accordingly, I strongly recommend investing in the company as overzealous focus on the risk of financials dissipates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: The distributor of this research report is not a licensed investment adviser or broker-dealer. Investors are cautioned to perform their own due diligence. We seek business relationships with all of the firms in our coverage, but research covered in this note is independent.