Morgan Stanley (MS 4.74%) has been a terrific stock to own over the past five years, delivering a 125% gain. The company has transformed into a high-return, capital-light bank focused on investment banking and asset and wealth management.
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Morgan Stanley has always excelled in investment banking. During the pandemic, management shelled out $20 billion to acquire E*TRADE and Eaton Vance, moves that propelled the company into a top asset and wealth management firm as well.
Morgan Stanley now targets a consistent 20% return on tangible common equity (ROTCE), and as such, has been rewarded with the highest valuation among its large bank peers.
MS Price to Tangible Book Value data by YCharts
Given Morgan Stanley's success, investors may be wondering how the company can continue to beat the market from here.
Morgan Stanley is fairly valued, with upside under the right macro conditions
In my view, Morgan Stanley is fairly valued, trading at nearly 3 times its tangible book value (TBV). TBV is simply a bank's equity minus goodwill and intangible assets, or what the bank would be worth if liquidated. Valuing banks based on their TBV is common practice.
The higher a bank's return, the higher the premium the stock can be awarded. The rule of thumb is that a bank with a 10% ROTCE should be valued at its full TBV. This means a bank with a 20% ROTCE should be valued at 2 times its TBV. This isn't a hard rule, and the market has likely awarded Morgan Stanley an even higher premium due to its capital-light structure, potential for deregulation, and strong market conditions.
But this is also why I view Morgan Stanley as fairly valued right now. So how could it beat the market from here?
Morgan Stanley's two main areas of business
Morgan Stanley's business is concentrated in two main areas. There is the institutional securities division, which consists of investment banking activities, including serving as an advisor on mergers and acquisitions, helping companies go public, and raising debt. The division also includes institutional trading for equities, fixed income, and commodities.
Then there is asset and wealth management, which typically involves a range of investing activities on behalf of clients that produce fee income. These divisions can also include other services, such as holding clients' assets and, in some cases, certain types of lending.
The institutional securities division will perform better in a lower-interest rate environment and a more stable market. Higher valuations, which also tend to occur in a lower-rate environment, can also lead to more IPO activity. Trading desks can thrive in a volatile market, which leads to more buying and selling of assets and, in turn, more commissions for the bank.
Wealth and asset management can benefit from a higher market because more assets under management (AUM) generate more fees.
