1 Big Bank That's Safe and Cheap

Sometimes the best stock bargains hide in plain sight.

Banking giant Wells Fargo (NYSE: WFC  ) (NYSE: WFC  ) has booked record earnings three years in a row. With consent from the Federal Reserve, dividends are up big since 2010, and another good bump in the payout is expected this year. The bank sports premier return-on-equity and return-on-asset figures versus peers.

Yet Wells Fargo remains significantly undervalued.

Price and earnings move in tandem
Over time, stock prices and earnings track each other. Investors pay for what a company earns, coupled with its future earnings expectations. Wells Fargo is a compelling undervaluation case, becoming separated from historic norms as a result of the financial crisis.  

Over the past 15 years, Wells Fargo has compiled an average, normalized price-to-earnings ratio of 15. During this same period, annualized earnings grew at 8.3%. However, in 2010 something changed. Investor fears about the general banking industry compressed the P/E multiple. Currently, Wells Fargo trades at an 12 P/E multiple, despite its record earnings.

According to, Wall Street consensus indicates Wells Fargo is expected to grow earnings by an average 7.3% a year over the next 5 years.

Therefore, if the forward earnings growth rate is expected to about the same as the long-term historic EPS growth rate, why should the P/E ratio be compressed by 3 multiple points?

Since investing is about probabilities, would you think it reasonable to premise that eventually the stock price, earnings and P/E will converge again? If so, you join investors who believe "reversion to the mean" is a  likely scenario.

Therefore, placing the long-term 15 P/E ratio upon the $4 EPS consensus 2014 forecast, the stock has an expected fair value of $60. One may purchase shares today for about $45.50 each. This indicates the stock is undervalued by 32%. The current 2.6% dividend yield is added gravy.

What about banking peers?
Some investors cite big banks Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) as undervaluation candidates since their stocks fell so hard during 2008-09. Citigroup stock now trades for about a tenth of what it did before the crash; Bank of America at less than a third of its 2006 peak. Don't these stocks have far more upside potential?

Well, let's look at the relationship between these banks' long-term multiples, earnings growth history, and forward EPS forecasts alongside what we already know about Wells Fargo.

P/E Multiples and EPS Growth Rates-- Wells Fargo, Citigroup, Bank of America
  Wells Fargo Citigroup Bank of America
Current PE 11.9 11.4 17.7
Historic PE 15 14 15
Historic EPS Growth% 8.3 NMF* NMF
Forecast EPS Growth% 7.3 9.2 8.3

NMF stands for non-meaningful figure. Note: Historic P/E ratios are 15-year averages.  Historic growth rates are annualized, 15-year operating diluted EPS.  Forecast EPS growth rates are taken from and represent analyst consensus annualized growth rates for the next 5 years.

First, we see these 3 banks all have similar long-term historic, P/E multiples of about 15. Next, we notice how Wall Street projects each of these banks to grow operating earnings at about the same rate. While Wells Fargo has been chugging along growing the bottom line at about the same rate both past and present, Citi and Bank of America have shown nowhere near such earnings consistency.

Yet Mr. Market places the highest current P/E on Bank of America's shares, and much lower ones on Citigroup and Wells Fargo. Bank of America certainly seems overpriced, at least when measured by historic standards, and compared with future expected earnings growth.

One could argue that Citigroup has yet to deserve a higher multiple, given its numerous historical problems, poor investments, and missteps.

This doesn't mean that Citigroup or Bank of America cannot go up, nor are they poor long-term investments. It just indicates Wells Fargo is not only safer, but it's perhaps not getting the respect it deserves.

Wells Fargo has generated far better returns, plus has an outstanding short-term, 5-year EPS growth track record. What's more, Wells' investors enjoy a 2.6% dividend yield with excellent forward prospects for increases. Meanwhile, Citigroup and Bank of America currently offer shareholders a miserly dividend of less than 1 percent.

What's going on here?
There are likely a few issues at play. 

Wells Fargo has long focused upon providing traditional "Main Street" banking services: taking in customer deposits, writing mortgages, and making community / business loans. The business model is simple, safe and effective. Wells' stricter underwriting standards helped keep its credit quality better than its competitors throughout the banking crisis. 

On the other hand, Citigroup and Bank of America took on far more risks and are dealing with far more headaches today. Citigroup was left holding the bag on billions in toxic securities, while Bank of America inherited the majority of its issue via acquisitions.

While Wells Fargo has fully recovered from the financial crisis and continues to register record earnings, Citigroup and Bank of America continue to struggle under the weight of litigation, government intervention, and jittery investor confidence. For the long-term investors, Wells Fargo still looks like the best deal. 

Is Wells Fargo the strongest bank out there?
Many investors are terrified about investing in big banking stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

Read/Post Comments (2) | Recommend This Article (2)

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  • Report this Comment On February 15, 2014, at 1:46 PM, PEStudent wrote:

    I own both Wells Fargo and Bank of America and if I could hold one bank for both preservation of assets and a realistic long-term expectation of approximating or beating the avg. market gains, I'd pick Wells Fargo because of its durable competitive advantages and relative stability.

    But I think Bank of America is likely to outperform over the next 5 years or so, depending on litigation.

    You note:

    "Yet Mr. Market places the highest current P/E on Bank of America's shares, and much lower ones on Citigroup and Wells Fargo. Bank of America certainly seems overpriced..."

    This is something of an illusion because BAC only returned to every-quarter profitability in 2013 and it's eps is growing fast as it recovers back to it's normal level.

    The 8.3% consensus annual BAC growth rate for the next 5 years you got from Zachs does not agree with the consensus from Yahoo (20.7%) or S&P which notes that after eps of $0.90 in 2013, it projects $1.29 in 2014 (43% annual growth) and $1.59 in 2015 (23% annual growth). Even if it didn't grow beyond $1.59 for the following three years it would have an avg. 12% annual growth rate for 5 years.

    Additionally, BAC hasn't requested a release from the TARP regulations to increase its dividend from 1 cent/quarter/share, but it will surely do so, probably to the 2% to 3% range, in the next year or so IF most of the litigation fizzles out or settles low as expected.

    Finally, note that BAC is being pummeled by bad news due to lawsuits, fines, and other court actions, but it's biggest problems are behind it and they had a downward effect on eps. That's holding the price down and, everything else being equal, is a good reason to buy.

  • Report this Comment On February 25, 2014, at 8:30 AM, RayMerola wrote:

    PE Student

    Thank you for a thoughtful and rational response. Indeed, much of BAC's future is premised upon forward earnings. Robust growth in the 20% per annum range does change the calculus.

    I also agree that Bank of America has several overhangs that Wells Fargo does not. If these are successfully removed, there's upside in the shares.

    Personally I seek banks stocks that are safe and cheap. I own such stocks for steady earnings, growing dividends, and sound management practices.

    I concur that Bank of A has more potential to "pop" than Wells. And it very well may do so.

    However, as you indicated in the beginning of your comments: Wells Fargo has better long-term competitive durability and franchise strength. Hence, "Safe and Cheap." BAC (and for that matter C) may be cheap contingent upon earnings forecasts. These names may not be so "safe."

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Raymond Merola

Ray Merola has over 30 years’ investing experience. He advises investors to find securities selling below fair value and “Get Rich Slow.”

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9/2/2015 3:01 PM
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