- Financial stocks are generally believed to benefit from rising interest rates.
- Higher interest rates will lead to higher revenue, and possibly, higher net interest margins.
- We estimate that TD is currently undervalued.
As we enter the final quarter of 2021, rising interest rates appear to be the talk of the street again. Financial stocks are generally believed to benefit from rising rates. The Toronto-Dominion Bank (NYSE:TD) is a great choice for those looking for exposure to the financial sector.
The Impact of Higher Rates on Banks
Many market participants assume that when the Federal Reserve begins tightening monetary policy that banks will be better off because their net interest margins will also increase. However, we would like to make investors aware that this isn't always the case. While revenue may increase, net interest margins don't always follow the same pattern.
Net interest margin is a measurement comparing the net interest income a financial firm generates from credit products like loans and mortgages, with the outgoing interest it pays holders of savings accounts and certificates of deposit.
Although higher interest rates mean that banks charge customers more, it also means that the banks' cost of borrowing also goes up. Over short periods of time, banks can actually increase their net interest margins when rates decrease as demonstrated in the image below.
As you can see from this picture, a rise in rates did not coincide with a rise in net interest margin most of the time. To understand why this happens, we need to remember that banks borrow short-term and lend long-term. A quick look at TD's balance sheet shows that the maturities of assets are skewed towards the long-term while the maturity of liabilities are skewed towards the short-term.
Therefore, when rates fall the banks are able to reduce borrowings at a faster rate than their customers. This gives banks a short-term margin expansion. However, eventually clients do renew loans at lower rates and the net interest margin comes back down.
Thus, the key takeaways are:
- That rising interest rates should be considered more of a setup to boost net interest margins after interest rates fall.
- The key driver of net interest margin is the timing of maturities between assets and liabilities.
The risk to TD is that the market may price in high earnings growth expectations going forward because of the belief that rising rates will boost margins more than they actually will. However, this currently isn't the case because the stock is trading below fair value as you will see below.
We will value TD using a dividend discount model. To demonstrate the stock's value, we will use a single stage DDM. Our assumptions are as follows:
- Equity risk premium: 4.7%
- Risk-free rate: 1.5%
- Beta: 0.87
- Cost of Equity: 5.59%
- Perpetual growth rate: 2.05% (set to the 30 year US gov't bond yield)
- Dividend per share: $2.50 USD
Fair Value = 2.50 ÷ (0.0559 - 0.0205)
Fair Value = $70.62 per share USD
As you can see, TD is trading under fair value if we simply assume a 2.05% percent growth rate using the current discount rate. We believe it is likely to grow faster than that.
TD is a dominant player in the Canadian banking industry. In fact, it is the largest of the Canadian Big 5 in terms of total assets. As most are likely aware, the Canadian banking sector is an oligopoly. The advantage of this is that TD is very profitable. As a result, the company has the ability to grow through acquisitions. It has been active recently with the acquisitions of Headlands Tech and Wells Fargo's Canadian Direct Equipment Finance business. It seems likely that TD will continue acquiring to help boost some of its growth.
Furthermore, although the overall net interest margin trend for banks, in general, had been declining in the picture posted earlier, it's important to note that the timeframe for that picture ended in 2015. Once we include more recent data, we can see that the margin did in fact increase with rising rates.
We suspect that the reason for this dramatic difference is because banks went from earning near zero on government treasury bills for customer deposits to earning above 2.5%. Therefore, under the current market scenario, it seems likely that TD may see a boost in margins if interest rates rise.
We believe that TD is a safe long-term investment. The company is currently undervalued even when using a very conservative valuation. The market is essentially pricing in approximately 2% long-term growth under current market conditions. We believe this to be overly pessimistic for a high-quality company such as TD.
This article was written by
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