This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
Surprise, surprise, Goldman Sachs was right.

As fellow Fool Rick Munarriz said yesterday, the polar opposite to discount brokers trash-talked its competition last week, warning that low interest rates and lost fee revenue would soon take a bite out of cut-rate profit margins at discount brokers like E*TRADE Financial (NASDAQ:ETFC), TD AMERITRADE (NASDAQ:AMTD), and Charles Schwab (NASDAQ:SCHW). Fast-forward a few days, and what did we see but Schwab itself, warning of low interest rates and a $0.02 to $0.04 hit to earnings. But now that the short-term carnage has run its course, out comes another full-service broker, and Goldman rival, with an upgrade of Schwab this morning.

Arguing that: "Schwab has maneuvered well during the downturn" and does not deserve to be valued on earnings "estimates at or near trough levels," Deutsche Securities upgraded Schwab to "buy" this morning, and set a $25 price target on the shares. While agreeing with Goldman about Schwab's short-term difficulties, Deutsche sees the discount broker turning around sharply in fiscal 2011 and beyond as profits surge "60-80%+ [to the] upside in the next 2-3 years."

Not so fast there, Tex
Brave words indeed -- but is Deutsche right? Here at the Fool, we've recommended that Motley Fool Stock Advisor members invest in Schwab, so obviously I'd love to be able to tell you that Deutsche is right on target with this upgrade.

Problem is, it's record argues otherwise. Name a broker, any broker, and chances are good that Deutsche has lost money recommending it at one time or another:

Throughout the length and breadth of the Capital Markets industry, Deutsche has racked up one of the worst records in investing history: 613 percentage points worth of market underperformance -- 18% accuracy on its picks. You read that right. Deutsche guesses correctly less than one time in five. With a record like this, why in heaven's name would anyone care what Deutsche has to say about Schwab?

Don't overthink it
If that sounds like a trick question -- it isn't. The answer is that you should ignore Deutsche's advice entirely. Clearly, this analyst's opinion of brokerage stocks isn't worth the virtual paper it's not printed upon. But just because Deutsche doesn't know the value of financial assets from a hole in the ground doesn't mean Schwab's a "sell." To the contrary, Schwab could very well be worth owning at today's price.

Huh?
Apologies for the head fake, but here's the point I want to make (in a nutshell). Ignore Deutsche's worthless opinion. Focus instead on Schwab's numbers.

Post-Monday's sell-off, Schwab carries a market cap of roughly $21 billion. Valued on its GAAP earnings of $931 million, that price looks rather steep. But if you look a little deeper, and notice that Schwab generates 34% more "free cash flow" than the "accounting profits" it reports under GAAP, the picture begins to look a little different.

Based on the $1.25 billion in free cash flow that Schwab generated over the past 12 months, Schwab sells today for just under 17 times its annual cash profits. With most analysts predicting that profit will expand 20% next year, and that Schwab will average better than 16% growth over the next five years, the shares look pretty fairly priced today. Tack on a tidy 1.4% dividend yield, and I suspect the stock could outperform the market once we get this pesky Great Recession behind us.

Foolish takeaway
This, dear Fool, is the reason to own Schwab today -- its free cash flow and its dividend yield. Unlike the opinions of a lousy analyst, Schwab numbers don't lie. And they tell me the stock just might be a "buy."

Disagree? Feel free. Come on over to Motley Fool CAPS and tell us whether you think Schwab will outperform the market. Don't be scared to guess wrong -- you can't go any wronger than Deutsche already has.