This is part three of our three-part series on Charles Schwab (NYSE: SCH). Here are Part 1 and Part 2 for your perusal if you're just joining us (and if so, welcome!). Last week I left you with a promise to assess Schwab from a qualitative Rule Maker perspective. So without further ado...

Dominant Brand
Dominant brand is really our attempt as Rule Maker managers to capture sustainable competitive advantage (SCA). Often a strong brand is the result of SCAs. Brand is intangible, delicate, and can take decades to refine, which is precisely why we love a well-manicured brand. Charles Schwab's brand is as good as it gets.

Even stock-market-oblivious folks who think a ticker is just another name for a pacemaker recognize the name Charles Schwab. Chuck has transformed his namesake company into the de-facto online broker for the next century. With 415 domestic offices plastered throughout urban and suburban markets around the country ready to serve its 7.5 million account holders, Schwab is everywhere. But more importantly, it was there when we (individual investors) needed a bridge to the corner of Wall and Broad.

Several years ago, when narrow-minded CEOs like David Komansky at Merrill Lynch (NYSE: MER) were scoffing at "discount" operations, Schwab was opening up the investment book to millions of everyday Americans. Service at a reasonable price is what built its reputation and today Schwab has nearly a trillion (that's 12 zeros!) dollars in assets under management.

Go ahead, ask Grammy if she's heard of Charles Schwab. I dare ya. (Report your results in this one-question poll.)

Repeat-Purchase Business
I have your money, your investable money that is, and each time you want some, I charge you. The fees are relatively inconsequential to you, but when I aggregate them from my millions of customers, they begin to add up. Oh yeah, if you want your money someplace else, like with another broker, I will make it excruciatingly difficult, drag my feet, and as a last resort offer to lower my fees (for a limited time) if you stay. I am a broker. Wanna be me?

How often do people change banks or brokerage accounts? Don't know, but I am willing to bet it is not very often. Transfers are certainly not taken very lightly. I needn't worry about Schwab's 7.5 million customers bolting overnight. Suppose they did want to leave: Who are these hypothetically displeased customers going to run to? Schwab is consistently rated as one of the top online brokers by Gomez and held up well in J.D. Power's 2000 Semiannual Online Trading Investor Satisfaction Study. In fact, over the past 12 months, while the Naz was in its death-spiral, Schwab added more than 1.4 million new accounts worth more than $170 billion. Not bad for a third-rate online broker.

Expanding Possibilities
Anyone think online trading is still a fad? Anyone besides Mr. Komansky that is? Obviously I'm preaching to the choir here, but online trading is the way of doing business in this market. As younger investors mature and older investors educate themselves, online trading will be thought of the same way as ATMs. How did we ever live without them?

Unprecedented trading volume at both the Nasdaq and NYSE is making equity trading America's second-favorite pastime. Noteworthy is that the Nasdaq reported 9 days with more than 1.0 billion shares trading hands in 1998 and 136 days in 1999. By 2000, the Nasdaq was quoting the number of days with 2.0 billion shares traded and it was 47. Even as the market indices ebb and flow, volume continues to be the one staple. Below are the average daily volumes (in millions) for the Nasdaq and NYSE over the last four years.

             2000    1999    1998     1997
Nasdaq      1,750   1,080     802      648
NYSE        1,042     809     674      527

According to latest monthly report from Schwab, it handles around 10% of all daily trades. And just in case you thought Schwab was a one-trick pony with equities, a recent Reuters article reported that Schwab is performing 30% of all its corporate bond trades via the Internet. Twenty-five percent of Treasury and 10% of municipal bond transactions are now made online. Schwab also participates in corporate note programs with blue-chip companies like General Motors (NYSE: GM), United Parcel Service (NYSE: UPS), and Bank of America (NYSE: BAC) that allow smaller denominations (e.g., $5,000) of bond issuances to be purchased by retail investors. The issuers are happy to pick up the fees because retail investors usually hold the bonds until maturity. Schwab hopes to accomplish in the new issue and secondary bond market what it has in the equities market.

If there ever were an industry in need of better information, especially to retail investors, it's the bond market. Confusing fee schedules, high minimum purchase amounts, lack of pricing information, and illiquidity have all but kept the retail investor from this market. If any one company has the muscle and guts to change it, Schwab does.

Ah, the key to investing -- buying low and selling high. Without valuation measurements we'd never know when something is overvalued or undervalued. But what is the appropriate valuation yardstick?

If you're a regular reader, you may be surprised to read this, but for Schwab I am going to use the price-to-earnings ratio (P/E). Financial companies can "create cash" at will by selling receivables (known as factoring) or issuing short-term debt such as commercial paper. Therefore, I will use the P/E ratio to gauge Schwab's worthiness. Our rule of thumb for valuation of 2x/5y still applies. We want to see our investment double in five years. Period. End of story.

Currently Schwab, even after sliding from its 52-week and all-time high of $44.75, is currently trading at a P/E of 38 based on its current price of $26 and First Call 2001 consensus estimates of $0.66. That's pretty expensive relative to the S&P 500's P/E of 25.8. But consider, Schwab has delivered a 10-year annual growth rate of 31% for revenues and 41% for EPS. (You've been spared up to this point with the numbers. Sorry, I've got to do this.)

Currently, the five-year estimated EPS growth rate is 20% (i.e., analysts' "long-term growth guess"), just slightly less than Schwab's prior five-year EPS growth rate of 25%. The simple rule of thumb is, assuming a constant P/E multiple, EPS growth of 15% gets you a double in stock price over five years. But sometimes we are forced to question the current P/E. Below is a chart showing how the share price might vary in five years based on a range of EPS growth rates and P/E multiples.

 Growth            P/E Multiple
  Rate       20x    30x    40x    50x
  20%        $27    $41    $55    $69
  25%         32     48     64     81
  30%         38     57     76     95

According to the chart above, we need to maintain a P/E just under 40 to get our double (26 x 2 = 52) if the prognosticators are right about Schwab's growth rate of 20%. But given the potential for growth in its market, the praiseworthy management team led by co-CEOs Charles Schwab and David Pottruck (which was around five years ago and I expect to be around five years from now), and Schwab's brand, I'm betting average is not in the cards. If Schwab can eke out 30% EPS growth and trade at a P/E multiple equal to its earned growth rate of 30% (a Fool or PEG ratio of 1.0), a double is in the bag.

By the way, if you liked this type of analysis -- digging into competitive advantage, management quality, expanding possibilities, and valuation -- you have a treat awaiting you in our upcoming Rule Maker Seminar 2001: The Art of Rule Maker. More details to come.

And finally, a portfolio trade announcement. In the next five business days, we'll invest our February $500 savings in additional shares of Nokia (NYSE: NOK). Nokia has the healthiest balance sheet ($2.9 billion in net cash) and profit margins (13.0% net) in the industry. Meanwhile, competitors are struggling to turn a profit while Nokia continues to gobble up market share (31.7% in handsets). Just read Nokia's latest quarterly report (a pdf file) to get a sense of the breadth of expanding possibilities in wireless equipment, handsets, and mobile commerce. Nokia has its hand in all of these. From a current market cap of $161 billion, we think Nokia has a good shot at continuing to grow sales and profits in the 25-35% range over the next five years, and thereby double its stock price (i.e., 2x/5y).

Fool on!

Todd Lebor is a co-manager for the Rule Maker portfolio and lives in Alexandria, VA. At the time of publication, the writer owned shares of GM & SCH. Todd's other holdings can be found in his personal profile. The Motley Fool is investors writing for investors.