We’re in a tough spot-financial services companies, particularly banks, are getting hammered right now because of the sub-prime mess. When a stock gets hammered, the underlying company may become very attractive at the new price. Unfortunately, Morningstar doesn’t give us the free cash flow data for these companies, so we have to dive into the annual reports.
First, An E-mail or Ten
A number of people have asked me how to do this via e-mail and I’ve sent virtually the same response which is something to this effect:
Many financial services companies are difficult to value because they have so many diverse revenue streams that are tied to the performance of the stock market, the bond market, and/or the housing market. When a business has to rely on sales, it can control its growth (or losses); but, when a business has to rely on sales and uncontrollable forces, it forces me to lose some confidence in my valuation.
Difficult Business: Merrill Lynch
Take a look at the Merrill Lynch Statement of Cash Flows on the SEC’s EDGAR database. Some items that I have to wrap my head around are:
- Undistributed earnings from equity investments (too shady to rely on-what is it exactly? Can they be lost?)
- Other ($922 million of “other” cash-how can they show $922 million as “miscellaneous”? Shouldn’t we know where that came from to know if we could rely on it?)
- Trading assets (Like working capital, except it can be used or regenerated quickly. Problem is that we have to rely on Merrill Lynch’s ability to trade-can they do it effectively considering that most people can’t?)
- Trading liabilities (Like trading assets)
- Other, net (Again, miscellaneous cash. But $5.5 billion of uncategorized cash?)
What exactly is the cash that Merrill Lynch generates from its business of selling investments? If it had to stop trading and doing its other stuff, and focused solely on selling investments, what sort of cash would the business generate?
Now, I wouldn’t bother with an investment in Merrill Lynch. Why? Specifically because I know the financial services sector and I know how difficult and “grey” their business can be. It is well within my sphere of competence and I know that Merrill Lynch has a million different ways to generate cash, pretty much all of which are directly tied to the performance of the stock markets. When the markets are running up, Merrill will generally do better. When they tank, Merrill Lynch will suffer. I don’t like businesses that have to rely on such a volatile, uncontrollable variable.
U.S. Bank
To find the owner earnings of US Bank, you have to go to the statement of cash flows and calculate it by hand. Here’s the problem with Financial Services companies like banks: Capital Expenditures include more than just property, plants, and equipment.
How do banks make money? They earn interest on deposits and loans, take a cut for themselves, and give the rest to their depositors. To do that, banks must purchase and sell loans or they won’t be able to pay the savings accounts and CDs and they’ll lose their business.
If you look at the 2006 Statement of Cash Flows for US Bank, you’ll notice two line items under “Investing Activities”: Proceeds from sales of loans and Purchases of loans. Without those “capital expenditures”, our bank is probably going out of business, so we need to reduce owner earnings to reflect that.
US Bank’s Owner Earnings
To calculate US Bank’s 2006 owner earnings, we subtract the net loan expenditures and any property, plant, and equipment CapEx from the Net cash provided by operating activities.
As it turns out, US Bank does not have any property, plant, or equipment capital expenditures in 2006, so our calculation is simple:
| 2006 | |
| Net Cash From Operations | $ 5,429 |
| Proceeds from sale of loans | 616 |
| Purchase of loans | -2,922 |
| Property, plant, and equipment | 0 |
| Owner Earnings | $ 3,123 |
As always, we calculate that for the past ten years to get an idea of US Bank’s growth.
The Result
There is no real consistency in US Bank’s numbers, so I don’t quite know if US Bank has peaked or if it is poised to grow. Of course, the past is supposed to give us insight into the future-not predict it. We can make assumptions even if the past is volatile, but it is riskier.
In the banking business, there is little need for moat, but it helps. US Bank has a competitive moat over its much smaller competitors, but has fierce competition at its size.
Still, US Bank has a value. If we were to assume that US Bank could increase owner earnings by 10% a year for ten years, and then slow to 3% for the next ten (no moat, fierce competition…lower expectations). Using a 15% discount rate, US Bank’s intrinsic value in 2007 is around $64 billion.
I don’t know how confident and comfortable I am in my predictions and assessment, but I still need to check the market to see if I am getting such a massive discount that I can afford to gamble a bit.
Value Vs. Market Cap
As it turns out, US Bank is trading right around its intrinsic value of $64 billion, or $33 a share. This is the norm as price generally follows value, assuming we have the right value for US Bank.
Check out this graph of US Bank (PDF, 42kb) to see how price follows value in the long-term, though it can do anything in the short-term.
Would I Buy?
No way. Reread this post and look at all the holes and speculation in my assessment. What did I do? I guessed at a bunch of numbers (because there was no consistency) and ended up with a value without any real data or reasoning-not a good way to make money.
Remember: Investing doesn’t have to be that hard. If you love the financial services sector, go for it. If you are looking for value and growth, stick with the easy, no-brainer companies, valuations, and investments.
Filed under: How to Think About Investing
Related Stocks: USB
Hi Pete,
Just like many financial services companies, the growth, cash flow, and overall intrinsic value of REITs are all tied to a number of markets – specifically, interest rates, real estate in general, mortgage rates, etc.
I don’t really like REITs in general because they are, in my opinion, too much like mutual funds. That is to say: I can go out and buy real estate or CMOs without having to pay the REIT managers and expenses. Add to that the fact that I would have to pick apart their loan portfolio to expose the weakness or risks of their business and REITs quickly move to my “Too Hard” pile. They’re just not worth my time when there are so many simple businesses offering great value.
In the end, I prefer to own businesses or real estate (or bonds or mortgages) directly rather than add a layer of managers, fees, and complexity.
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Joe,
I agree in your assumption that these financial services stocks are pretty hard to value. I’ve spent some time looking over Countrywide’s Balance Sheet. Given the volatility in the secondary market (it’s practically illiquid at the moment). I’m worried about the way they came up with the valuation of their investments in loans that they are holding (somewhere near the tune of $75 Bln). I’d love to know what kind of paper they are holding and how that is performing, a 20% decrease in value would pretty much give the company a negative net worth. Regardless, I still adore Angelo Mozilo’s tan and the fact that he converted stock options at an accelerated pace this year (right before everything started going bust). I’m sure it was just good timing. Anyhow, I love your website. It’s not really a fun time owning a mortgage company right now. Anyhow, miss you, miss Bromley Hall, miss Pauly’s wallruns, miss your old room at Bromley. Good times!
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PDH – I feel for you during these rough mortgage times and I am totally jealous of Mozilo’s tan. And I too miss Paulo’s wall runs and the $0.50-you-call-it at KAMS.
Yes, MikeR, I did a stretch at the University of Illinois at Urbana-Champaign. Bromley Hall, breakfast at IHOP, late night LaBamba. I might have attended a class or two at some point. I had a friend at Purdue so we would shoot over there for Acre Shaker and hit some bar for scooners (or spooners? I can’t remember).
Oh, don’t get me started on college stories or this blog will turn ugly…
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LOL Joe, it is a small world. We might have been at the same Acre Shaker.
It is schooner, a type of beer mug.
I’m going to knock back a Guinness or two this evening.
Again, many, many thanks for all the knowledge you are providing here. I can’t wait to purchase your book.
Have a great weekend.
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Hi Ron,
I haven’t seen a simple, no-brainer bank/financial services company yet; but, there are plenty of companies that are simple and grow steadily. The universe of these companies is small, and they are rarely underpriced. That’s exactly why we need to be patient and wait for the great opportunities.
The “simple, no-brainer” concept applies to all stocks, not just financial services. Adobe Systems – simple (to me), no-brainer (to me), but fairly valued. I have to wait for the market to beat Adobe to the ground before I can buy it. Will I miss some growth? Probably. But I don’t want growth…I want super growth with little to no risk.
Keep turning over the rocks. Eventually a company will jump out at you. Those are the ones you want to put your money in.
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Joe , superb posts again and I can’t believe how rich this site is within only a few months of inception. Can you imagine what this will be in a few years? If this site were a publicly listed company, it would be my biggest long. Of course I will be eagerly waiting to buy your book.
Two questions though –
1. Agree Financial stocks often fall into the “Too Tough” category, but what makes Wells Fargo different from the others, in your opinion? What do you see in their financials that makes Buffet like this over all other Banks and Financial Services Firms?
2. Any idea about how to value Commercial or Home residential builders ( Like KB Home, Hovnanian etc? ) . Particularly any red flags or key items to be sensitive to?
Many sell side reports tout the low ( even less than 1 ) price to book ratios of these companies, stating that they are now selling at “below replacement cost”, but these companies could always continue to mark down the real estate holdings and thus book values ( or worse still, not take these charges and keep us in the dark). How would you go about valuing these firms? Certainly they have been beaten down quite a bit and might offer potential bargains to the keen investor.
Thanks again for your great posts and stellar website. Jay
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Jay,
If this were a publicly traded company, I’d tell you to RUN! F Wall Street generates negative owner earnings as I personally pay all the costs and don’t pump it full of ads. ☺ I hope I can keep it that way; then again, there is a certain something to being CEO of NYSE listed FWS (the ticker is available!)
1) Financial firms are too hard for me. Buffett has always marvelled at banks, however, because moat is virtually a non-issue. Once people start with a bank, it is like pulling teeth to get them to switch and the market is never really oversaturated. When I get back from (or while on) vacation, I’ll take a more in-depth look at Wells Fargo.
2) Builders are tough to value. They have huge capital outlays to start, are highly sensitive to interest rate fluctuations, and have considerable freedom in how they value and report their assets. Who really knows what a home built from raw land is worth until it is sold? Sure, they can speculate, but where does that put us?
If home builders and real estate are in your sphere of confidence and competence, by all means take a look. The valuation is always the same: How much cash can be taken out of the business during its remaining life. Answer that…and you’ll find your bargains.
Hope that helps!
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Trying to figure out why you back off net loan activity on the owner earnings calc for banks? To me it is not the same as capex. but more like the other activity reported there, short-term available for sale securities. Would you be so kind as to explain a little more why you are backing off loan purchases? I understand that is using cash, but in a productive way, that has a relatively liquid value, almost like cash. So trading cash for another form of cash, that earns more. ? Thats my take. Not as much time delay or risk associated with building a new plant for example that has to get to capacity etc. Any further thoughts would be welcome, am I missing something?
Thanks Joe!
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Hi Casey,
Expanding on the post above, if U.S. Bank didn’t buy and sell loans, it wouldn’t generate the interest it needs to pay depositors. If it can pay depositors, it can’t keep its clients. As such, I consider loan acquisitions and sales as crucial to U.S. Bank as factories are to Ford.
Though CapEx is traditionally “Plant, Property & Equipment,” that is an IRS rule, not a business owner rule. To business owners, a CapEx is anything that the business must buy and use to maintain (or grow) its operations, but can’t (or shouldn’t) expense in earnings. For many financial services companies, that includes investments and loans that are necessities, not luxuries.
Make sense?
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I disagree with your post regarding capital expenditures include the buying and selling of loans. The reason bank’s buy and sell loans is effecient deployment of capital. Instead of reinvesting excess deposits into treasuries which earn a substandard return, banks have the ability to use their highly leveraged balance sheets to borrow from depositors and invest at a premium into loans to make a larger spread. Larger banks have more diversification and in US Bank’s case a large trust department that helps boost returns via fee income.
Banks do not have to make loans. They could simply buy securities/treasuries with depositors money and go along with their business. The reason they make loans to for the benefit of their shareholders and not the depositors. Rates on the savings accounts are driven by the loan demand and not the other way around. I think this is where you are going wrong in your assumption. CDs and savings accounts are funding lines. You can bring in deposits easy by just increasing the rates you pay. It is the no interest deposits that bank’s mouths wet over and in that case you are paying nothing to the depositor.
It is easy to get lost in the numbers but I encourage you to look at the numbers of some smaller banking institutions. I think you will find where loan demand is low banks pay near nothing for deposits and have a large security portfolio or participation/syndicate loan portfolio. Buying and selling loans is an investment strategy that is necessary in the banks but should not be classified as capital expense. They certainly are not necessaties but more so a path to higher returns for their shareholders in my opinion.
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Andy,
Admittedly, banks are tough for me to value. My view on their loan purchases as CapEx is the same as Ford. Ford doesn’t need to build new plants or upgrade equipment – they can invest their cash in treasuries as well. But that will only get them so far.
You said, “You can bring in deposits easy by just increasing the rates you pay.” But how do banks get those higher rates? They have to acquire loans that will pay enough interest so that the bank can take their spread and give the higher rate back to the depositor.
How would a small bank make money if it didn’t loan out deposits (or acquire loans with deposits)? Investing in treasuries will likely hinder their growth. In the same way, Ford can keep pumping out vehicles on their old equipment, but the quality will continuously decline and their customer base will dry up.
Then again, this is outside my sphere of competence so this discussion is all in the interest of learning (for me, at least). You said something interesting: “The reason they make loans to for the benefit of their shareholders and not the depositors.”
If I am going to be a shareholder in US Bank, and US Bank has to buy these loans to increase owner earnings and grow, I would consider those loans to be mandatory in the ordinary course of business – a cost of doing business, and a charge to owner earnings because the company has to spend that cash. Though not technically a capital expenditure, I would consider it as such for the purposes of calculating owner earnings and the business’ value.
My two cents on it.
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Joe, I was thrilled to see you address the banks, but not so thrilled to see you come to the same conclusion as me — TOO HARD!
I’d love to read your take on REITs, specifically Mortgage REITs, which are terribly beaten up lately. Personally, I also put these in the ‘TOO HARD’ category (what with having to know a lot about the quality of loans), but I’m hoping you’ve got an insight.
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