# 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.

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.

1. […] recently valued the company, and suggested a reasonable price range between $50-$60. I suggested accumulating […]
2. […] right now. At one point in the year, however, it dipped to nearly $43. In August, I argued WFC was probably worth$60/share, and it would be a good idea to accumulate it under \$48. I steadily built a 5.5% position in the […]