Deutsche Bank: Buy The Dip?

| About: Deutsche Bank (DB)

Summary

Solid average interest margin over the past 10 years.

DB is currently trading at a significant discount to net tangible asset value, sales, cash and FCF.

Long-term bullish stock or options play.

Like all major investment bank stocks, Deutsche Bank's (NYSE: DB) stock has been tumbling since the financial crisis due to lower-trending long-term interest rates and loose monetary policy. Its stock is down almost 55% this year. Another big name, Credit Suisse (NYSE: CS), is down almost 50% this year. Barclays (NYSE: BCS) is down almost 44% this year. UBS (NYSE: UBS), down 25%, and even Wells Fargo (NYSE: WFC), is down 7% this year. Highly prestigious Goldman Sachs (NYSE: GS), is also down almost 7% this year. This article looks at DB's profitability and valuations compared to other top 10 global investment banks, and deduces that there is strong value potential.

DB headquarters in Frankfurt, Germany. Source: wsj.com

Recent Ruckus

Deutsche Bank was brought up in the news regarding a potential $14B fine a couple days ago to settle claims over its issuance of residential mortgage-backed securities prior to the financial crisis, causing the stock to drop 12% over the last couple trading sessions. DB stock is currently trading at an all-time low of $12.97, and this raises the question of how undervalued the stock is. DB is a prominent top 10 global investment bank, and when global economic conditions improve and rates increase, DB's tough days will soon be forgotten.

Solid Net Interest Margins Over the Past 10 Years

A common profitability measurement for a bank is its net interest margin, which is basically the difference between interest income generated by the bank and the amount of interest paid out, relative to interest-earning assets). Although DB's net interest margin is higher now than it was 4 years ago, current global deflationary pressures have created uncertainty regarding net interest margins for virtually every bank in the global sector.

An at-a-glance analysis compares the average net interest margin of DB relative to other top global investment banks.Source: Averages and data collected from gurufocus.com

DB's average net interest margin over the last years is a strong 1.685%, higher than half of the global investment banks shown in the table I created above. Other stocks like JPMorgan (NYSE: JPM) also have stellar net interest margins and are trading near 52-highs, and don't have as strong valuations, as you'll soon see. As long-term interest rates are expected to rise over the next year or two, DB should continue to profit off of stellar margins and more comfortably control any volatility from net interest margins going forward. In fact, even controlling for the current price per share, DB's price / average net interest margin, scaled by 100, comes in at 7.94x, as shown in the Excel table I created below. Source: data compiled from gurufocus.com

This means that investors are only paying $7.94 for every 1% (100 basis points) of net interest margins that DB has to offer. This multiple is the third-lowest in the entire distribution. Barclays Capital and Bank of America (NYSE: BAC), are also trading on the extreme side of the scale). Goldman and Morgan Stanley (NYSE: MS), appear to be trading too high relative to their 10Yr average net interest margins, as compared with the rest of the top 10 global investment banks.

Net Tangible Asset Value per Share Discount

Another useful valuation metric to consider is the net tangible asset value per share. This multiple is calculated by computing the current total assets, subtracting any intangible assets and total liabilities, as well as any preferred equity, and dividing this quantity by shares outstanding. The table I created below in Excel shows the calculations for the net asset value (NAV) per share.Source: data collected from gurufocus.com

Total assets represent what a company owns. As of June 2016, DB had more than $2.026 trillion in assets, $11 billion in intangibles, just under $2 trillion in total liabilities (both short-term and long-term obligations), and no preferred equity outstanding. Preferred equity actually has a liquidation order preference over common equity, so it's more realistic to treat preferred equity as a form of debt. Shares outstanding are almost 1.4 billion, so the net asset value per share comes in at $45.88, almost a 3.5x premium above the current price of $12.97. This means if DB liquidates all its liquid assets, writes down its intangible assets (intangibles can't be sold that easily), pays off ALL its obligations, then this residual asset value would be worth about $45 per share to equity shareholders. This provides a huge margin of safety. Considering that intangible assets like intellectual property could actually have their rights sold to buyers, this net asset value per share is a conservative estimate, assuming assets can be liquidated at current or book value.

Source: data collected from gurufocus.com

DB's price / NAV multiple is also the lowest in our entire top 10 global investment banks universe, as you can see from the chart I created above. Stocks like Citigroup (NYSE: C), Credit Suisse, and Barclays, are also trading lower than the industry average NAV multiple.

Revenue per Share Discount

Another valuation multiple we could consider is the price-to-sales multiple, which takes the current market cap and divides by recent sales. DB's P/S currently stands at 0.69x times sales, which is the lowest multiple in the entire global investment banks industry.Source: data collected from gurufocus.com

For a company that had more than $36B in USD revenue last year, it seems that DB's growth decay is highly oversubscribed. Our sales multiple tells us how the market is pricing in DB's top line value. Yet common sales and earnings multiples might be a bit misleading for equity investors, as we mostly care about current free cash flow and the growth in the free cash flow. DB is also currently trading at a P/FCF multiple of $0.19x, which is the lowest FCF multiple out of 4,868 stocks. The price-to-FCF multiple of $0.19 means that investors are only paying $0.19 for every $1 of recent free cash flow, which seems like a bargain, considering DB's net asset value per share is more than 3.5 times its current share price.

Additionally, DB also has the lowest P/C multiple out of again 4,868 stocks. Its current P/C multiple of $0.04 means that investors are paying a mere 4 cents for every $1 Deutsche holds in cash and cash equivalents on its balance sheet. From an objective perspective, it seems that the market is more concerned about DB's short-term performance versus its long-term performance, which provides an opportunity for an investor.

Potential Options Trade Analysis

Investors with an average risk appetite could simply go long DB shares, while providing record-high margin of safety on their position. Investors with higher risk appetite could buy long-term call options on DB. Call options have limited downside risk because the most you can lose is what you pay for the option contracts. Call options also in theory have unlimited upside potential. You could then research the optimal call option conditions you want exposure to.

Call Option Key Takeaways

A call option gives you the right but not the obligation to buy an underlying before or at some specified date in the future, at some specified price (strike price). If you buy a call option with a strike price below the current underlying price, that's called being In the Money, or ITM. If you buy when the strike is above the underlying price, that's called Out of the Money, or OTM.

Upside Potential

Call options are more commonly sold back to the market before expiration than exercised, since the upside potential from capital appreciation is higher than from exercising. That's because if you buy an OTM call option and the underlying increases to even just below the strike price (a point where you still wouldn't exercise), you could still make about 5-10% of your investment already, provided you didn't pay much for the calls. Further stock/underlying price increases in excess of the strike price would therefore provide significantly leveraged returns.

Downside Potential

The downside risk with options is that you can lose your entire investment. There's a concept in options called theta decay that at its extreme basically says even if the stock goes nowhere, your call options could lose value because the closer the option gets to expiration, the smaller the probability the stock going above the strike (In the Money), so the more rapid the option price decays.

Source: http://www.optionsplaybook.com/

As you can see from the plot above, if you buy a call option at $1.7 and it has 90 days until expiration, at around 30 days left, it will be worth about $1.00, if the stock goes nowhere. Thus, if the stock doesn't move in the first 60 days of the position, an investor would typically lose about 30-40% of their investment when the option has 30 days to expiration, and would likely prudently sell in the last 30 days to prevent further losses.

I collected quotes for DB call options on Sep. 19, 2016, with strikes ranging from $3 to $30 for Jan. 2018 expiration and strikes going from $3 to $30 for Jan. 2019 expiration, along with their option Greeks. I selected long-term options to provide investors with a long-term safety net in case global economic conditions don't improve in the next 1.5-2 years. The 2018 calls expire in 487 days and the 2019 calls expire in 851 days.

The collected information is shown in the excel spreadsheet below, and I discuss how the final ranks are created, and the analysis is conducted first on the 2018 calls and then on the 2019 calls.

Source: Quotes taken from TD Ameritrade on 9/19/16

Source: Quotes taken from TD Ameritrade on 9/19/16

As an investor, you buy a security at the ask price and sell at the bid. Thus, if you wanted to buy the DB Jan 18 2019 $20 strike call, you would be paying $1.7 per option "share". Since you buy options in lots of 100, each contract would cost you $1.7 x 100 = $170. I recently created a similar options play analysis on the ETFS Physical Silver Trust ETF (NYSEARCA: SIVR), which you can read on Seeking Alpha here. The analysis is similar, but provides an example with put options instead of call options.

Delta/Ask Ratio

The delta of a call option measures the probability that the stock/underlying price will go above the strike price during the option's life, and is positive. Notice that your ask price increases if you choose a call option with a lower strike because the probability of you gaining on your position increases. There's basically a trade-off between what you pay and the delta of your option, and since we are bullish on DB, we want to maximize our delta/ask ratio. The higher the delta/ask, the bang for your buck.

Bid Ask Spread

You compute the bid ask spread as 100 x (ask - bid) / ask. This tells you how much you would lose on your position if you bought the option at the ask and sold right away at the bid, ignoring transaction costs. The smaller the spread, typically the more liquid the asset, and the more the option is active when market-makers quote their prices.

This means if DB suddenly spikes upwards after you buy the calls and you own a liquid call option, if you wanted to sell, you would probably sell at a better price than if you owned an illiquid call option.

You therefore want to minimize the bid ask spread if you think the market may possibly go against you and you want to sell after you open the trade. It's also important to know that if your call option becomes deep In the Money after a couple of months, your spread will probably be wide but you wouldn't care that much because you would have made a profit.

If you're completely confident of the direction of your underlying, you wouldn't really care that much about the option's bid ask spread when you open the trade, since you would sell way later.

Implied Volatility

An option's implied-volatility (IV) has a direct effect on its price. As IV decreases, the option price decreases, and as IV goes up, the option price also goes up. You want to buy an option cheap and sell it at a higher price so you would want to buy a low IV option, where the market is not pricing in large potential moves, either on the upside or downside.

Important Observations

Based purely off of the delta/ask ratio, the DB Jan 2018 $25 call provides the best delta for what you pay for and has below average IV compared to the average IV of this strike chain, and has a slightly below average bid ask spread.

The $10 strike call in the 2018 strike chain has the lowest bid ask spread. However, this call option has a lower delta/ask than the average and a slightly higher than average IV, so you're probably paying too much.

You basically want to equally rank these 3 option factors for each strike chain to get a sense of which option is the best across the board for you to buy.

Final Option Rank

A higher delta/ask ratio may be more favorable to investors with high confidence so you standardize the delta/ask distribution with the delta/ask mean and std. dev. A lower IV is better if you're confident on the direction of the bet so you standardize the IV distribution with the negative of the IV mean and the std. dev. A lower bid ask spread is typically better so you standardize the bid ask spread distribution with the negative of the bid ask spread mean and its std. dev.

You then take the average of your 3 standardized variables and sort the strike chain from highest to lowest according to this new final weighted average. As you can see, the $25 strike and the $15 strike calls provide the best bang for your buck within the Jan. 2018 strike chain, and the $20 and $25 strike calls also provide the best bang for your buck within the Jan. 2019 strike chain.

You're receiving solid delta for what you pay, you have good liquidity and your IV is low, meaning you're buying these options cheap. You do this because you are confident the underlying will go down before the option expires, so you don't mind paying a low price now, which factors in a lower probability of profit, as seen by the general market.

Summary

It seems that the market has in appropriately tagged Deutsche Bank with low market multiples according to the firm's profitability, real asset base and revenue potential. Secular trends in the global banking sector have not been kind to bank stocks in general, and recent events have caused many strong companies with a significant global presence to be grossly overvalued. DB's 52-week low of $12.58 may prove to be a solid support level in the price slumps further, but the stock is already a strong bargain opportunity with a huge margin of safety. Investors could go long with common stock positions or could potentially earn leveraged returns using long-term call option positions, if the global economy strengthens within the next couple of years.

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.

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