Wells Fargo - 10% Higher Or Lower?

| About: Wells Fargo (WFC)
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Previously I detailed why you might not want to sell shares of Wells Fargo, even if you believed the value was a touch too high.

This article looks at what the difference could be between buying at a 10% higher or lower price.

While a lower price is obviously favorable, the takeaway is a bit broader than that.

Disciplined investing can often mean the difference between average returns and very solid gains. Note that I didn't say the difference between positive and negative or "good" and "bad." The investing world is a largely profitable place, so over the long-term things generally work out well or really well.

This idea is highlighted by the notion that historically the difference between buying at the best possible time each year and worst possible time is a few percent worth of annual compounding. To be sure this can add up, but even if you happened to invest at the worst possible moment year-in and year-out (something that wouldn't actually occur in practice) you can still do alright.

I'd like to apply that concept to Wells Fargo (NYSE:WFC). Recently an analyst came out with a price target for Wells Fargo that was about 10% lower than the previous close. Based on this judgment, the analyst then concluded that it was time to sell Wells Fargo. Of course there are a variety of considerations - ranging from the potential for faulty estimates and tough comparisons to frictional expenses and a lower price actually being good news - that could mitigate this notion. Basically simply believing that shares ought to be worth slightly less may not be enough to throw away a perfectly good partnership.

In the previous article I presented a largely theoretical case. For this commentary I'd like to think about the situation using some numbers. That is, for the Wells Fargo shareholder what's the difference (or perceived difference) if you were to buy shares at a 10% higher or lower price?

To answer this question, we'll have to come up with some hypotheticals - as is always the case when contemplating a company's future. Banks in general have more regulation, exposure to cyclical industries and ongoing financial concerns going against them. On the plus side you have the possibility of higher rates and comparatively low valuations. This last part can be important, as the payout ratio might be lower but this still allows for a reasonable dividend yield and more effective share repurchase program.

I've seen intermediate-term growth rate estimates for Wells Fargo ranging from 6% to 9.5%. Let's use the lower end of that range: 6% growth for the next decade. Some might cry foul here, but I think it's important to remember a couple of things. One, this is merely a demonstration - you can change the baseline to your preference. And two, even during 2005 through 2015, when you had the Great Recession and share count dilution, Wells Fargo still grew earnings-per-share by nearly 6% per annum.

If earnings-per-share grew by 6% for 10 years, after the decade you'd be looking at a per share underlying earnings claim of about $7.40. Over the past decade the average earnings multiple for Wells Fargo has been around 13. Let's use 12. That equates to a future expected price of about $89 (and remember, this is just a baseline).

The current dividend payout ratio sits at about 35%. Let's suppose this can grow to 40%, indicating a yearly payout growth rate of just over 7%. In total an investor might anticipate collecting $22 or so in dividend payments over the 10-year period. If you add this to the expected share price of $89, you come to a total value of $111.

This is all interesting to map out, but it doesn't yet tell you much about the value proposition being offered. That depends on the price that you pay. As I write this shares of Wells Fargo are exchanging hands around $47.50. So let's look at three scenarios: $47.50, $42.75 (10% lower) and $52.25 (10% higher).

Here's a summary of what that might look like:

In all three instances a share would deliver the same amount of dividends and end up with the same share price. We're using $22 and $89 in this instance, but this holds regardless. Your purchase price does not affect what ultimately happens to the share price (presuming small purchases).

What the timing of your purchase does influence is how many shares you're able to buy with a given level of capital and how much resulting income will come about. This may seem obvious - the lower you buy the better off you'd be - but there are still some important takeaways.

Naturally the 10% lower price would provide the highest benefit, given the eventual assumptions detailed above. The benefit is obvious. The risk is a bit more hidden: there's a possibility that this price may never occur again. So you could be waiting for an opportunity that is already solid to become even better and end up not partnering with the company at all. This is a very real risk.

With the current price, you can buy now presuming you have the funds to do so. The benefit is that your anticipated return is still quite solid. The potential downside is that shares may go lower. Personally I'd see this as an opportunity (through "fresh" capital, reinvestment or on your behalf with share repurchases you're still a net buyer) but it remains as a possibility that may cause angst nonetheless.

Finally, you're very likely to get an opportunity to buy shares of Wells Fargo at a 10% higher price in the future. Which I think makes a couple of interesting points. First, it shows that even if the share price goes higher all may not be lost for the long-term owner. When you see a price quote of $48 and then $52 a couple of months later, you may be anchored to that previous low point and not want to buy. Yet this doesn't mean that your potential returns suddenly went from reasonable to negative. As illustrated above even a 10% higher price could very well mean solid gains for the long-term investor.

A secondary aspect that I'm reminded of is Tim McAleenan Jr.'s notion that "a good deal is not diminished because an even better deal was once offered." He aptly noted that Warren Buffett was buying shares of Wells Fargo in the $10's, $20's, $30's and $40's and continues to buy today. Just because you could once buy under $20 doesn't mean today's value proposition is lost. Just because someone buys an avocado for 30 cents doesn't mean that 50 cents is automatically a bad deal.

It's obvious that a security is apt to provide better returns at a 10% lower as compared to higher price. Yet that shouldn't be your only takeaway. It can be just as important to recognize the risk of never buying shares by waiting for a lower price. Moreover, even if shares go higher all may not be lost. Ten or twenty years hence stock prices are likely to be materially higher than they are today, and yet there will still be attractive securities to choose from that will offer substantial long-term wealth creation.

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.