I want to highlight one deal still available on the market hiding in plain sight, Wells Fargo. So often we think we have to search the outer reaches of the magical stock market kingdom to find value. Today we'll look at how Wells Fargo offers outstanding value and significant upside. Secondly, I will keep this short and sweet. I have been recommending Wells Fargo to a number of people and today I will spell out why it's a great deal.
Wells Fargo - A Fantastic Business
Since I want to get directly to the valuation of the company, I wont waste much time singing the praises of the company. Wells Fargo is truly is a fantastic business. It has a huge deposit base that is very, very low cost and it has among the largest net interest margin of all the large banks. You can think of net interest margin as the gross margin for a bank. I tell people it's the difference between the interest rate on a loan (loan interest rate) and the funding interest rate (deposit interest rate). This is because of the community banking focus.
As I have said before, during financial crisis of 2008, Wells Fargo would have been the last bank standing. The credit default swaps barely moved compared to the much riskier banks. Also during the credit crunch they were also able to pick up Wachovia on the cheap. (Don't take my word for it read the takeover proxy yourself)
Wells Fargo - A Fantastic Valuation
As for valuation, the company is selling for roughly $23.50 ($23.36 Friday's close). The trailing 12 months earnings per share is $2.58, giving it a trailing P/E ratio of 8.7 times. That is a 11.5% earnings yield (earnings per share divided by the share price). Now we must stop here and make a few comments. This is one of the truly outstanding companies in the USA. As an owner you are effectively getting a very good return on your capital today, in the rear view mirror, not some pie in the sky future estimate. Lastly, the company is operating in some very difficult conditions given the recent recession and very weak loan growth. The company does has money to lend to credit worth borrowers. If the company were to pay out the historic rate of 45% of earnings as dividends, you would be earning a 5.1% dividend yield, today not tomorrow. You also benefit from the large amount of retained earnings to fund future growth.
Now lets stop and take a look into the future. I have done my own analysis and believe the company will earn approx $4.10/shr in 2013. You may rightly suggest that I am am only an "armchair" analyst, what do I really know? Well to calm the critics, let see what First Call has to say about the analysts who cover Wells Fargo. A polling of 27 analysts estimate the company will earn $3.49/shr in 2012 and $4.05/shr in 2013. Let's all be pessimistic and agree on $4.00 per share of earnings in 2013.
What does that mean for a valuation? Well in two years time the company will be good for a 17% earnings yield. Again, if they pay out 45% in dividends that will be good for a 7.7% dividend yield. Plus you will also benefit from the growth provided by the retained earnings. By 2013 the company will be more than able to pay out a much large percentage of earnings as they will have enough capital to meet Basil III requirements.
Today you can use the "recession fear" to become an owner of one of the best banks in the USA for approx. $23.50/shr. Profits for this year will come in at around $2.80/share. Under normal circumstances (not raising capital) that would be good for over a 5% dividend yield. This is not pie in the sky but actual money they are earning TODAY. In two years profits are estimated to be up 44% to $4/shr, and dividends will be approximately $1.80/shr, giving a 7.7% dividend yield (based on today’s price).
By 2013 I would expect two things to happen. First, as already mentioned, the company will be earning closer to $4/shr (44% growth), and the P/E multiple should expand from the current 8.7 times to a more normal 14 times earnings (55% growth). This would place the value of the common stock at around $56/shr, giving dividend yield of 3.1% ($1.80/shr dividend divided by $56/shr price).
Lets be conservative and say the share price only gets to $50 per share (~12 times earnings) in 2013, that would mean you double your investment in around two years. That works out to be a 42% annual return excluding dividends. Let’s just say even if I am wrong and wrong by a lot, Wells Fargo is very cheap.
The funny thing is, none of this is private information. It’s easily accessible to anyone with a computer and half a brain.
I don’t find it surprising the Warren Buffett was buying more Wells Fargo in the second quarter. The cheapest Wells Fargo reached during the second quarter was approximately $25.36/shr. Today you have an opportunity to buy Wells Fargo 10% cheaper than Mr. Buffett was recently buying it for.
Wells Fargo is Warren Buffett’s second largest holding, behind Coca-Cola. Do you want to wager a guess about what he things about the company and it’s future prospects? Don't bother fretting over the current macro problems, and focus on doing one thing... Buying Stocks Cheap.
Disclosure – I've been adding to WFC recently.