Fannie and Freddie: How High Can They Soar?

Ackman calls for a 10-bagger return. Does an adjusted earnings analysis agree?

Mar 3, 2014 at 9:50AM

G

Shares of Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC) have soared over the past few weeks as investors hope these GSEs can return to private hands. With these GSEs reporting billions in quarterly profits and big name investors jumping on board, it's time to examine what the potential upside really is for Fannie and Freddie shareholders.

Common vs. preferred
For average investors, there are two main ways to invest in Fannie and Freddie: Common stock and preferred stock. Both took major hits during the mortgage meltdown and trade well below their potential values due to the GSEs' arrangements with the government.

The upside for preferred shares is easier to calculate. Like other preferred stocks, Fannie and Freddie preferreds have liquidation values that give a fair estimate of their value in a situation where dividends are being paid. The most liquid preferreds trade with liquidation values of $25 and $50 giving them the potential to nearly triple in the event the GSEs can return to private ownership.

The value of the common stock, however, is more difficult to calculate -- but with currently available information, we can get a general estimate.

Earnings view
Current headlines show that Fannie Mae reported a profit of $84 billion for 2013 however that figure is not a good way to measure company value. The $84 billion is largely driven by the recognition of deferred tax assets, a one-time event rather than a recurring one. A more accurate picture would come from excluding the $50.6 billion gain from the deferred tax assets resulting in $33.4 billion in net income for 2013.

Freddie Mac received a similar benefit from the recognition of deferred tax assets. Subtracting the $30.4 billion DTA gain from Freddie's $48.7 billion in net income gives a figure of $18.3 billion.

Both GSEs have benefited (and could still benefit in the future) from legal settlements with the banks that sold Fannie and Freddie the defective mortgages before the crisis. But since the settlements are not going to be a perpetual part of income, I will discount 30% from future estimated income.

Applying a 10 times price to earnings ratio to these settlement-adjusted earnings would give Fannie Mae a market cap of $234 billion and Freddie Mac a market cap of $128 billion. Investors also need to factor in the warrants owned by the Treasury to acquire 79.9% of Fannie and Freddie's common shares. With these warrants exercised, Fannie's shares outstanding would rise to 6.0 billion and Freddie's would rise to 3.3 billion.

Taking these market caps divided by these shares outstanding yields an estimate of $39 for Fannie Mae shares and $38.79 for Freddie Mac shares. Of course these are just rough estimates -- a more realistic prediction would be that shares of the GSEs could reach the upper $30 to lower $40 range.

Book value?
Looking at other financial institutions book value can be a good indicator for assessing over or under valuation. For example, one of the core arguments for being bullish on Bank of America (NYSE:BAC) is the bank's discount to book value. The idea here stems from that if the market regains confidence in the bank and sees a larger dividend, shares should move toward the bank's book value.

However, Fannie and Freddie have a major difference from Bank of America since the GSEs have to turn over their profits on a quarterly basis to the government. B of A, on the other hand, can retain, reinvest, and distribute earnings as dividends.

For this reason, it's better to look at the GSEs on an earnings basis rather than a book value basis, like investors would value other large financial companies.

Upside and risk
With billions in quarterly earnings, shares of Fannie and Freddie have major upside if the lawsuits to end the Sweep Amendment are successful. Bill Ackman, manager of Pershing Square, has made a major investment in the common stock of both GSEs and recently talked of returns of 10 to 15 times the current value.

Shares of the GSEs were lower when Ackman made the comment last week, but the potential for multibagger upside still remains. By looking at the GSEs earnings, excluding one-time DTA gains and reducing them to factor out legal settlement gains,  I have found potential upside to nearly $40 per share at each GSE, largely in line with Ackman's estimates. For investors who can afford to lose their investment if things go bad, Fannie and Freddie still offer some of the greatest potential gains in the market today.

One company outgrowing the GSEs
Opportunities to get wealthy from a single investment don't come around often, but they do exist, and our chief technology officer believes he's found one. In this free report, Jeremy Phillips shares the single company that he believes could transform not only your portfolio, but your entire life. To learn the identity of this stock for free and see why Jeremy is putting more than $100,000 of his own money into it, all you have to do is click here now.

Alexander MacLennan owns common shares of Freddie Mac, is long Jan 2015 $20 calls on Bank of America, and is long Bank of America Class B warrants. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. 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.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers