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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
And speaking of the best…
… Goldman Sachs upgraded E*TRADE
But it might be good advice.
Let's go to the tape
Oh, I know what you're going to say. Considering its day-job is stock-broking, Goldman doesn't really have that great of a record picking brokerage stocks. It was wrong the last time it told investors to buy E*TRADE (in late 2009). It was wrong to pan OptionsXpress last year, as well. On the other hand, though, Goldman was right about Schwab underperforming the market, and right about AMERITRADE outperforming:
Goldman's Picks Beating (Lagging)
|TD AMERITRADE||Outperform||****||12 points|
|OptionsXpress||Outperform||****||(36 points )|
Source: Motley Fool CAPS.
And call me crazy, call me a Fool -- but I think Goldman's got a good chance of being right about E*TRADE today. Why? Well, let's think about this a bit.
Will the real E*TRADE please stand up?
What is E*TRADE, exactly? On the one hand, it's a discount stock broker -- that's what all the pop-up display ads tell us. But the company also offers checking, savings, and money market accounts to its customers. And we know it's had problems with bad mortgage loans on its books, so clearly it's a lender as well. But Schwab and AMERITRADE offer bank account services, too. Bank of America
Clearly, there's overlap in E*TRADE's business model, too. In fact, that overlap seems to account for part of Goldman's optimism about the stock. The analyst notes that one reason it prefers E*TRADE over AMERITRADE, for example, is the fact that E*TRADE has "lower exposure to transaction-based revenue" -- stock trading commissions. Still, while that's an incremental positive, to me E*TRADE remains first and foremost a discount broker, and a banker only second.
And it's E*TRADE's identity as a broker that has me thinking Goldman just might be right about the stock's undervaluation. Consider: Alone among the big-three publicly-traded discount brokers, E*TRADE shares sell for less than the company's own book value. AMERITRADE sports a 2.9 price-to-book ratio. Schwab shares fetch 3.3 times book. But E*TRADE has a P/B of less than 0.9.
E*TRADE's role as primarily a purveyor of stocks also gives me some confidence in valuing the stock on its free cash flow (which can be tricky with pure-play banks.) Over the past year, E*TRADE has generated some $1.4 billion in free cash flow from its business. This makes the company's valuation of less than three times FCF look very attractive to me. And even if viewed from an enterprise value-to-free cash flow perspective, the resulting multiple of less than nine seems cheap relative to consensus analyst projections for strong double-digit earnings growth.
Investing in a hybrid business like E*TRADE is always a tricky proposition -- and an exercise in risk-management. To me, though, the margin of safety on this one looks very wide, and the prospects for profits -- enormous.
Prefer to try "before you buy." Add the stock to your Watchlist, and get a better feel for how the E*TRADE story is playing out before investing in the stock.
Fool contributor Rich Smith does not own (nor is he short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 520 out of more than 170,000 members.
Charles Schwab is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Bank of America and JPMorgan Chase, and in a separate account in its Rising Star portfolios has a short position on Bank of America. 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.