Long-Term Potential in This Recovering Stock

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When it comes to brokerages, especially as investments, E*Trade  (NASDAQ: ETFC  ) is in a class by itself. It is valued differently than its competitors, offers a different mix of products, and targets a completely different demographic.

Shares have literally doubled in value since the beginning of the year. This will probably dissuade many potential investors from further consideration. I believe, however, that the market simply wised up and is now pricing in what some of us have known all along: E*Trade isn't going anywhere.

Not all brokerages are the same
E*Trade is one of the leading online financial services companies. I use that term instead of "brokerage" because its services certainly extend beyond those of rivals TD Ameritrade (NASDAQ: AMTD  ) and Charles Schwab (NYSE: SCHW  ) . E*Trade does offer extensive online brokerage services, and has done a great job creating a very user-friendly interface that offers the most features in the industry. For example, E*Trade offers direct trading on six international markets in five different currencies, making it easy for investors to hedge their portfolios with foreign stocks and currencies.

The company also has a banking segment, offering checking and savings accounts. E*Trade used to be a big player in the residential mortgage market, but it discontinued such activities after incurring severe losses during the mortgage crisis. The company still has a portfolio of mortgages, most of which are adjustable-rate, in addition to other various consumer loans. As of the most recent quarter, E*Trade's loan portfolio totaled $9.6 billion, down about half a billion from the previous quarter.

Where the other two lack the broad spectrum of features offered by E*Trade, they make up for it with their financial stability. However, I think the others may be a little too expensive right now. TD Ameritrade, for instance, trades for 23.7 times trailing-12-month earnings, which is too much for a company projected to grow by 8% annually over the next several years. Schwab is even more expensive at 33.2 times earnings, and even though it's projected to grow at a slightly faster rate than TD Ameritrade, it still doesn't justify such a high valuation.

Neither company pays an especially good dividend, and neither company seems to have tremendous room for expansion and/or earnings growth.

Why the dramatic increase in share price?
The recent developments with E*Trade that have caused the excellent stock performance can be mainly characterized by an improving financial position. For instance, E*Trade's Tier 1 Leverage Ratio, which is the relationship between a bank's core capital and total assets, has improved to 6.4% from 6% from last quarter (4% is the minimum requirement). E*Trade's Tier 1 Common Capital Ratio, which is generally considered the best measure of a bank's financial strength, has improved from 11.2% to 12.2%. A company is categorized as "well-capitalized" with a ratio of 6% or more, the highest categorization possible.

Another reason the market may look upon the company very favorably is that it seems that E*Trade will actually return to profitability this year. The consensus calls for $0.66 in earnings per share this year, rising to $0.77 and $1.01 over the next two years, respectively. The company's book value has been steadily rising since the crisis has passed and is now about even with the share price. What this tells me, especially the recent price action, is that the market finally feels that all of the risk is sufficiently priced in, and it looks like the company's book value is creating somewhat of a "price floor."  

What the future might hold?
Currently trading for just over book value, I think E*Trade is still a bit cheap at current levels. Over the past few years, the company has taken prudent steps to improve its financial health and build its customer base, and while I have no delusions that E*Trade will be valued at its peer average of 2.9 times book value anytime soon, it is completely reasonable to set a price target of 1.5 times book for a year or two out, especially if the company's fundamentals continue to improve as they have been.

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