Ask Chuck about Schwab

Charles Schwab (SCHW) offers brokerage, banking, wealth management and financial advising services. It is one of the largest brokerage and banking firms in the US, founded in 1971, with over 330 branches, almost all of which are in the US.

Resources

Some useful reports on SCHW on the web are listed here:

  • Boyar Research put out a case study in Sep 2013 (pdf) with an estimated value of ~$32/share. At the time SCHW was trading at $14.
  • The Brooklyn Investor looked at SCHW in Aug 2015, after Lou Simpson had established in a position. At the time SCHW was trading at $30, and BI thought that it was relatively cheap (14x PE) if interest rates normalized.
  • In Feb 2017, Argus Research put out a note arguing SCHW was worth $46, when SCHW was trading in the low 40s.

Background

Like Vanguard, SCHW provides real value to its customers.

It lead the drive to lower commissions, ramped up its ETF business with Vanguard like expense ratios, proactively waived client money management fees due to low interest rates, and starting to snowball its RIA services. It is a top notch company, leverages its scale in the brokerage and banking businesses, and has a potentially long runway in front of it.

A company creates value when it grows revenues, and commands high returns on capital. SCHW checks both these boxes.

Over the past 5 years, SCHW has grown revenues at 10%, EBIT and net income by over 15%/year. Operating and net margins have been relatively stable around 35% and 20%, respectively.  Book value has also grown at 15+% rate, while the return on equity has been in the 11-14% range.

SCHW has been able to crank out this amazing performance, despite multiple headwinds. The most significant challenge is the low interest rate environment. It is possible that some of these headwinds will slowly turn into tailwinds.

One can make a reasonable case that the current EPS ($1.30+) greatly understates the true earnings power of the business.

The company lays out the key drivers of near-term value in their April 2017 “Spring Business Update” presentation.

Screenshot from 2017-04-29 23-01-08

Essentially, the company is doing what it can to grow profitably. It cannot control a few factors, like taxes and interest rates. The current climate seems to suggest that both these factors might swing in favor of SCHW. As an example, each 25bp rise in interest rates increases cash flow by about $250m.

Valuation

There are several ways of valuing a high quality company like SCHW.

IRR =ROE

The ROE for SCHW is 10-15%. If interest rates rise then hitting or even exceeding the upper end of that range is likely. If one holds SCHW for a long time, then one should expect return to match ROE.

While this exercise doesn’t give us an intrinsic value, it tells us that if the valuation doesn’t change while one holds the stock, the gravitational pull (or push) is towards this 10-15% return.

10x PTI

Now let us consider Buffet’s 10x PTI rule for high quality businesses. Last year PTI was about $2.25/share, which would put the value around $22.50/share. This is nearly half of the current market price (~$40). As stated previously, SCHW is currently a coiled spring. If interest rates go up by 2%, PTI will go up by nearly $1.60/share, resulting in a 10x PTI of $38/share.

Financial Services Company

We can value SCHW using the equity method.

BV = book value of equity = $16,421M
ROE = return on equity = 15%
COE = cost of equity = 10%
nNI = normalized net income for next year = ROE * BV = $2,463M
g = stable earnings growth into perpetuity = 5%
p = dividend payout ratio = 1 - g/ROE = 67%
Equity Value = nNI * p/(COE - g) = $32,842M
Shares Out = 1,324 M
IV/share = Equity Value/Shares Out = $25.

This gives us a value of $25 without any sudden improvement in interest rates or the tax environment. To justify the current price of $40, we need to either get to high ROEs (20%, at 5.5% growth), or sustain much higher growth rates (8% at 15% ROE).

Summary

In the long-term, there are many ways to win with SCHW, because the intrinsic value is constantly increasing. There are not too many ways to lose, although depressed interest rates can impair its underlying earnings power.

Estimates of value are all over the place. The floor seems to be somewhere around $25 (a price it was trading at not too long ago) – and can be justified essentially if nothing clicks as hoped. On the other hand, the current price of $40 seems fully priced, and assumes about a 1-2% increase in interest rates in the next year or so.

Yes, SCHW is an above average business, and probably deserves a premium. It is stock that one could hold on to for a long time, without any headaches. Perhaps, a good strategy might be to scale into a position in the $25-35 range.

If the market undergoes a correction (as it certainly will sometime in the future), I might have to keep an eye out for SCHW. But right now, it is a pass.