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 Zacks.com, 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.
|Wells Fargo||Citigroup||Bank of America|
|Historic EPS Growth%||8.3||NMF*||NMF|
|Forecast EPS Growth%||7.3||9.2||8.3|
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.
Raymond Merola is long WFC and WFC warrants. This article is not a recommendation to buy or sell any stock. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.