WFC: How Far will Wells Go?

Wells Fargo (WFC) is Berkshire’s favorite stock. And for good reasons:

  1. In the past 50 odd years, it has grown deposits at a remarkable rate of over 10%. This is faster than the overall banking deposit growth, which in turn has outstripped GDP growth for nearly a century.
  2. WFC’s average ROE has been in the 15% range. It retains about 2/3 of its earnings, and pays out the remainder in dividends. It has been doing this consistently for a long time. Not surprisingly, its book value has grown by approximately, ROE * retention ratio = 15% * 2/3 = 10%.
  3. For a company with ROE of 15%, a thumb-rule often used for the financial industry suggests an “appropriate” P/B of 1.5 (10 * ROE). I learned this from the Brooklyn Investor. WFC’s P/B ratio has historically hovered around this number.
  4. Banking is a very profitable business, as long as it is run carefully. WFC passed the real-life 2008-2009 stress test with flying colors.

In short, WFC is a safe, consistent, compounding machine.

Review

Investments in compounding machines have two value drivers:

  • the return on equity, (say \alpha )
  • relative valuation at the buy and sell points

Let r be the rate of return, and P/B be our measure of valuation. Suppose we buy at a valuation of PB_0, and sell it n years later at a P/B ratio of  PB_n. The relationship that holds all these numbers together is:

\left( \dfrac{1+r}{1+\alpha} \right) = \left( \dfrac{PB_n}{PB_0} \right)^{1/n}

The rate of return is equal to the ROE in two special situations:

  • the relative valuation at the buy and sell points is the same (say P/B = 1.5), OR
  • you hold the position for a really long time

The rate of return is inexorably pulled towards the ROE, since the RHS of the equation above goes to 1 as n becomes large.

If you hold the position for a short time, and if the relative valuation changes over your holding period, then your IRR will be different (can be larger or smaller) from the ROE.

Valuation

There are lots of “short-term” numbers that one can come up with for WFC’s value.

The simplest perhaps is Buffett’s 10x pre-tax income (PTI) rule. Buffett has often said that for high-quality growing businesses, he is happy to pay up to 10x PTI.

For fiscal 2015, PTI was $33,641m. Subtracting preferred dividends ($1,424m), and dividing by the number of shares (5210m), I get an adjusted PTI of $6.18/share.

10x of $6.18, gives me a fair value of approximately $62/share, based on 12/2015 numbers.

To get a more updated view, I can look at current (and TTM) numbers.

The TTM PTI was higher at $36,926m; subtracting preferred dividends ($1,424m), and dividing by reduced number of shares (5067m), I get an adjusted PTI of $7.29/share, and a fair value of nearly $73/share.

WFC BVPS is currently $35.38. These numbers imply a P/B ratio of 1.75 and 2.0 at $62 and $73. This is somewhat higher than the historical norm.

The figure below shows WFC’s historic P/B ratio. Before the financial crisis, WFC enjoyed a much higher valuation of around 2.5.

PB

Since the Great Recession, the P/B ratio has ranged between 1 and 1.75. The $73 price target would expect WFC to break out of this range. This could happen, but there are two reasons to suspect why it may take a while (if at all):

  • Low Oil Prices: WFC has a $18B loan book, and about $13B reserves. While low or tepid oil prices don’t pose an existential threat, they can mar WFC’s near-term earnings.
  • Low Interest Rates: Despite WFC’s touted “low-cost provider” moat, it isn’t immune to compression of net interest margins (currently sub 3%).

On the flip side, if interest rates or oil prices trend up, WFC’s earnings would be boosted. If I use a 1.5 P/B ratio, then the fair value seems to be $53/share (1.5 * $35.38).

Summary

In recent years, WFC’s ROE has trended lower (about 12%) from its historic 15% ROE. It is possible that this is the “new normal”, and that these lower returns will persist for a long time. If the market thinks so, it might reward WFC with a lower valuation multiple (say 1.2 book, in keeping with the 10*ROE rule).

Here are possible “conservative” scenarios, listed in the order of decreasing probability.

  1. ROE returns to 15%, and P/B remains stable at 1.5 (IRR = 15%)
  2. ROE drops to a stable 10%, and P/B drops to 1.0 (IRR = 6.66%)
  3. ROE drops to a stable 10%, and P/B persists at 1.5 (IRR = 10.0%)

I don’t know what the likelihood of these scenarios is. Perhaps it is 50%, 35%, and 15%. I don’t know. If I buy at P/B = 1.5, the range of outcomes is 7%-15%, with the scale tilted towards higher numbers.

The longer you hold, the less important relative valuation becomes. In that case, your IRR = ROE, which is expected to be in the low teens.

At the current stock price of $48/share, it is currently in the “great business for fair price” regime.

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