Deutsche Bank AG: Considerable Upside Potential

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About: Deutsche Bank AG (DB)
by: Frank Isaksen, CFA
Summary

Deutsche Bank AG trades at a low valuation based on book value.

Recent capital raise has reduced risk of equity shortfall.

The share price has a considerable upside potential.

Summary comments

Deutsche Bank (NYSE:DB) currently trades at attractive consensus valuation multiples. My thesis is therefore that Deutsche Bank offers an attractive risk/reward.

In this analysis, I will try to find out if Deutsche Bank is an attractive investment by conducting a valuation analysis on what I assume to be somewhat conservative forecasts. I also include risk assumptions in order to better understand the upside and downside potential. All numbers in this analysis are in EUR.

My summary conclusion from the below analysis is that I believe Deutsche Bank offers an attractive risk/reward.

Consensus forecast

Source

The downward revision in EPS may have bottomed out. (I do not know how updated these consensus forecasts are, and how they are aggregated.)

My forecast

My forecast is aimed to be somewhat conservative in order to test my thesis that Deutsche Bank is an attractive investment.

The forecast is mainly based on 2Q 2014 numbers (Source: Deutsche Bank) and the following subjective assumptions:

  • I assume that return on equity (ROE) will gradually increase to 8% by the end of 2017. Deutsche Bank management targets an ROE of 12% already by 2016.

  • I assume dividends in 2015 and 2016 respectively at 30% of net profit, and at 50% of net profit from 2017 onwards.

The below chart shows the resulting assumed expected EPS development.

The line until June 2014 shows the adjusted historical quarterly EPS (historic net earnings divided by current number of shares). The black (top) line shows the assumed future quarterly EPS in case return on equity gradually increases to 12% (Deutsche Bank management's target), and the green (lower) line shows the assumed future quarterly EPS in case return on equity gradually increases to 8% (my main assumption).

Forecast robustness

Deutsche Bank may face large fines for misconduct for the alleged manipulation of the foreign exchange market. Estimates I have seen estimates about the potential size of the fines have been around EUR 4.0 billion.

My 8% ROE assumption implies an ROE of about 10% if the equity were reduced by EUR 15 billion (i.e. written off). That is, my ROE assumption is targeted to be somewhat conservative even if the fines were up to EUR 5-10 billion.

Valuation

I use 2 different valuation methods.

Valuation method 1: Valuation using the dividend growth model, assuming a cost of equity of 8% and perpetual growth in dividend of 4% through the end of the explicit forecast period, gives the below result.

The blue bars shows the valuation per share (in EUR) in case the return on equity gradually increases to 12% (Deutsche Bank management's target), and the green bars shows the valuation per share (in EUR) in case the return on equity gradually increases to 8% (my main assumption).

Based on these 2 different return on equity assumptions, there is an implied upside potential of about 110% and 30%, respectively.

Valuation method 2: Valuation assuming current fair value should be 10 times EPS in 2017 and assuming a discount rate of 8% gives the below result:

The blue bars shows the valuation per share (in EUR) in case return on equity gradually increases to 12% (Deutsche Bank management's target), and the green bars shows the valuation per share (in EUR) in case return on equity gradually increases to 8% (my main assumption).

Based on these two return on equity assumptions, there is an implied upside potential of about 80% and 15%, respectively.

Consensus price target for Deutsche Bank is currently around EUR 32.

I have assumed a cost of equity of only 8% (due to deleveraging and a lower interest rate environment), which may be low compared to other Deutsche Bank valuation analysis. However, I have also assumed a lower ROE, that the normalized ROE materializes later, and a lower perpetual growth in dividends.

Valuation multiples

The charts below show yearly earnings per share (EPS), book value per share, price/earnings (P/E), price/book value per share (P/B).

The blue bars show the case where return on equity gradually increases to 12% (Deutsche Bank management's target), and the green bars shows the case where return on equity gradually increases to 8% (my main assumption).

Yearly earnings per share:

Consensus EPS forecast is about EUR 2.9 for 2015, EUR 4 for 2016, and about EUR 6.2 for 2017.

Book value per share:

Price/earnings (P/E):

Consensus P/E is about 9.4 for 2015, 7 for 2016, and 4.5 for 2017.

Price/book value per share (P/B):

Relative valuation

The below table show Deutsche Bank's valuation relative to some competitors (Source: Seeking Alpha).

From this table we can see that Deutsche Bank has a relatively low valuation based on book values relative to the other banks in this comparison. Deutsche Bank, however, is the only bank in this comparison with a negative trailing 4 quarters' net income and the only one that has recently had a major capital increase.

Forecast with uncertainty assumptions

In order to better analyze the risk/reward, I have included the following subjective uncertainty assumptions:

  • 20 basis points quarterly standard deviation in interest rate spread

  • 4% quarterly standard deviation in other revenues

The analysis below includes these risk assumptions and is based on my main assumption where return on equity gradually increases to 8%.

In this analysis, I calculate multiple scenarios where interest rate spread and revenues are subject to potential changes based on the above assumed standard deviation.

The sum of all the potential outcomes from these multiple calculations can be summed up in, for e.g., fan charts and distribution charts.

The fan chart below shows the resulting assumed possible quarterly net profit.

The fan chart shows the calculated outcomes including uncertainty assumptions. The black line shows the historic development, and the black dotted line shows my main forecast. The darkest blue area shows the range that contains about 75% of the calculated outcomes. The second darkest blue area, together with the darkest blue area, contains about 90% of the calculated outcomes. The total blue area contains about 95% of the calculated outcomes.

About 2.5% of the calculated outcomes are above the blue shaded area, and about 2.5% of the calculated values are below the blue shaded area.

The lower part of the fan range occurs in the scenarios where the Monte Carlo generated revenues are low and the Monte Carlo generated interest rate spread is low.

The upper part of the fan range occurs in scenarios where the Monte Carlo generated revenues are high and the Monte Carlo generated interest rate spread is high.

The fan chart below shows the resulting assumed possible quarterly earnings per share (where historic net profit is divided by current number of shares). This is the same chart as above just divided by current number of shares.

The fan chart below shows the resulting assumed possible quarterly book value per share.

The fan chart below shows the resulting assumed possible quarterly annualized return on equity.

Valuation multiples with uncertainty assumptions

Current share price relative to assumed possible future yearly earnings per share:

Assumed possible future dividends divided by current share price (assumed dividend as 30% of net profit in 2015 and 2016, and as 50% of net profit in 2017):

Current share price relative to assumed possible development in book value per share:

Valuation with uncertainty assumptions

The below valuation with uncertainty assumptions is based on my assumption that return on equity gradually increases to 8% by the end of 2017.

The chart below shows the assumed possible return on equity (annualized) at the end of 2017 used in the valuation range analysis below:

The distribution chart shows the distribution of annualized return on equity at the end of 2017 based on all the calculated scenarios. The horizontal axis shows the return on equity distribution, and the vertical axis shows the percentage of each outcome.

The percentage shown on each bar is the accumulated outcome starting from the left.

For example, 91.2% of the calculated outcomes have a return on equity of below 9.65%.

Valuation method 1: Valuation using the dividend growth model. Assumed dividend as 30% of net profit in 2015 and 2016, and as 50% of net profit in 2017. Assuming a discount rate of 8% and perpetual growth in dividend of 4% at the end of the explicit forecast period gives the following result:

Based on this valuation method, there is an estimated 10% probability that fair value per share is below EUR 30 (USD 38) and 90% probability that fair value is above EUR 30 (USD 38).

Valuation method 2: Valuation assuming P/E multiple of 10 on 2017 earnings.

Assuming current fair value would be 10 times EPS in 2017 and assuming a cost of capital of 8% gives the following result:

Based on this valuation method, there is an estimated 18% probability that fair value per share is below EUR 28.5 (USD 36.5) and 82% probability that fair value is above EUR 28.5 (USD 36.5).

Deutsche Bank's current share price is about EUR 28 (USD 36).

Conclusion

Deutsche Bank's recent capital raise has reduced the risk of equity shortfall and further dilution.

On book value valuation multiples, Deutsche Bank looks cheap relative to its international peers. On future earnings multiples, however, Deutsche Bank does not look relatively cheap until we include 2016 and 2017 earnings.

Deutsche Bank has had a rough recent earnings history, and there is still a significant risk that new adverse events may happen. For e.g. the potential fine for misconduct (alleged manipulation of foreign exchange market) may be much higher than what the market is anticipating (if the company is fined).

Assuming investors start believing Deutsche Bank manages to gradually increase return on equity to at least 8% by 2017, there is an 'okay' short-term upside potential in the share price of about 15-30% according to the assumptions used in this analysis.

If investors start believing in Deutsche Bank management's aspirations of 12% return on equity, then the short-term upside potential is considerably higher, about 80-100%. This again implies a P/B multiple of about 1.05 to 1.20 which is about where JPM and UBS are currently trading.

Including the potential uncertainties in the valuation analysis on a forecast that is meant to be somewhat conservative, I get a valuation range from about EUR 26 (USD 33) to EUR 40 (USD 51). Compared to the current share price of about EUR 28 (USD 36), it implies a return potential from about -5% to 40%.

I know there are many risks involved, but in this case, I feel opportunities outweigh the risks. I find Deutsche Bank to be an attractive investment.

Disclosure: The author is long DB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.