Is KBW Too Costly?

Shares of KBW (NYSE:KBW) closed Friday at $27.02, nearly 29% above the IPO price of $21 on Nov. 9. Based on the company's fundamentals, should investors expect the shares to go higher?

KBW is the holding company for Keefe, Bruyette & Woods, a boutique investment bank that specializes in financial services. Keefe has provided advisory or underwriting services in many recent and prominent transactions, including Capital One Financial's (NYSE:COF) pending acquisition of North Fork Bancorporation (NYSE:NFB) and Bank of America's (NYSE:BAC) acquisition of MBNA. Keefe also has a highly rated research department. In fact, Keefe's research team boasts wider coverage of U.S. banks, insurance companies, and asset managers than even the premier names in investment banking provide. Keefe's focus on the financial services sector -- with its substantial potential for continuing capital market and merger activity -- helps explain why investors so eagerly welcomed this IPO.

As a public company, KBW intends to extend Keefe's competitive strengths by expanding its investment banking operations in Europe and by developing its small asset management business. With this diversification, the company could reduce some of the volatility in Keefe's niche investment banking business. Investment advisory fees tend to be relatively stable, and a larger asset management business would help cushion any slowdown in revenue from investment banking or sales and trading.

KBW faces a number of significant challenges in its core investment banking and sales and trading businesses. Investors should be concerned about whether it keeps its employees, which is always important at service-oriented firms, but may be especially relevant to a firm that's so dependent on the notoriously mercenary labor of investment bankers. KBW's compensation expenses for bankers may never leave much profit for investors. Net margins were just 5.6% and 10.4% in 2005 and 2004, respectively. Return on equity was just 6.5% and 11.6% for those years.

The changing structure of trading commissions is another important concern for KBW shareholders. Managers of institutional funds have traditionally bought research in connection with the trading commissions they paid to firms like KBW in an arrangement known as "soft dollars." Recently, many clients have been seeking to "unbundle," or separate the cost of research from the cost of trade execution. This trend has contributed to the discounting of trading commissions and is expected to continue. Keefe's trading commission revenue has actually been climbing in recent years, but growth in Keefe's European operation is probably masking declining margins from sales and trading.

The risk factors in KBW's business would seem to argue against a big premium for the firm's shares. Yet KBW is now trading at higher multiples than other investment banks that recently went public, such as Thomas Weisel Partners (NASDAQ:TWPG) and Cowen Group (NASDAQ:COWN). KBW looks like a stock whose price may have gone too high.

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Fool contributor Michael Leibert welcomes your feedback. He does not have a position in the stocks of any of the companies mentioned above.