Is Schwab Stock Undervalued?

Charles Schwab (NYSE:SCHW) is among the largest financial companies in the United States. As the largest publicly traded brokerage in the US and a key provider of financial services, Schwab serves nearly 35 million customers.

Despite its standing in the market, however, Schwab has sold off by more than 30 percent this year amid general concerns regarding the health of the American financial sector. So, is Schwab stock undervalued now?

Why Schwab Sold Off

Charles Schwab was one of many financial companies that sold off in the wake of the Silicon Valley Bank collapse earlier this year.

Like SVB, Schwab held a substantial portfolio of bonds that declined in value as the Federal Reserve raised interest rates to counter inflation.

When SVB’s balance sheet effectively imploded, investors began to pull out of financial sector stocks en masse.

It should be noted that Schwab has remained profitable, even as its bond portfolio has declined.

In the quarter reported following the SVB collapse, the company detailed total profit of about $1.6 billion. Despite demonstrating its financial health and ongoing profitability, Schwab has still not recovered from the selloff it saw earlier this year.

Positive Earnings In Spite of Fears

Even while selling off more than 30 percent YTD, Schwab has posted very positive financial results over the past year. Q1’s earnings report detailed revenue growth of 10 percent year-over-year and GAAP net income growth of 14 percent. GAAP profit margins also extended from 39.4 percent to 41.2 percent.

Much of the seemingly strong investment thesis for Schwab today rests on its high rate of projected future growth. On the 3-5 year time horizon, analysts expect Schwab’s compounded annual earnings growth rate to average about 12 percent.

In the 2022 fiscal year, Schwab reported EPS of $3.66. Assuming the aforementioned growth rate, the company’s earnings could rise as high as $4.10 by 2025. This places the stock at a multiple of roughly 14 times its estimated 2025 earnings.

It’s also important to note Schwab’s highly positive profitability metrics. Over the last 12 months, the company has maintained a 34.8 percent net margin and a 27.8 percent return on equity.

For reference, the equivalent metrics for JPMorgan Chase were 23.7 percent and 16.0 percent, respectively. Net income totaled over $7 billion, showing that Schwab’s business model is still generating robust profits.

Analysts Target Price for Schwab

The median analyst target price for SCHW is $68, roughly 18 percent above the most recent price of $57.53. There is, however, very little consensus on Schwab’s short-term prospects among analysts. Price targets range from $49 to $85. Analyst ratings are far more uniform, as 15 of the 23 analysts covering Schwab rate it as a buy.

Adding to the confusion for investors is the fact that Schwab’s valuation metrics are heavily mixed. The company’s price-to-sales and price-to-earnings-growth ratios are both quite high at 4.7 and 3.3, respectively.

The forward P/E ratio is 17.6. This places Schwab well below the S&P 500 average P/E of 25.5 but above the average financial investment banking industry average of 13.5.

Discounted cash flow analysis, however, seems to tip the scales in favor of Schwab being undervalued. Using 2022’s earnings and the 12 percent projected earnings growth rate, the intrinsic value of the stock is likely between $72 and $75 per share. This projection implies a potential upside of 25 percent or more.

Charles Schwab Dividend Is Modest

Charles Schwab currently pays a modest dividend of $1 per share, making for a yield of 1.76 percent. While this yield is far from stellar, Schwab has the potential to be a strong dividend growth investment.

The payout ratio is under 30 percent, giving management ample room for future increases, especially if earnings continue to grow as expected.

Schwab only has a 2-year history of dividend increases, but this is entirely due to a pause that occurred in 2020 and 2021. 

Schwab still paid its dividend in 2021 but did not raise it. Over the last 10 years, Schwab’s dividend has more than quadrupled from $0.24 annually in 2013 to $1 today.

Customer Deposits Raises Concerns

The recent trend of declining customer deposits is cause for concern. Between Q4 2022 and Q1 2023, deposits dropped by 11 percent.

Meanwhile, Schwab has seen a migration of capital to interest-bearing accounts. This limits the company’s ability to generate revenue by lending out uninvested cash. If investors continue to use Schwab’s high-interest accounts instead of its brokerage services, the company’s profit margins could shrink over time.

Charles Schwab’s potential undervaluation also rests on the assumption that earnings will continue to grow at a fairly high rate over the next few years.

Given that analysts expect EPS to increase by nearly 30 percent over the coming 12 months, this assumption appears to be a reasonably fair one in the short term.

However, macroeconomic headwinds, including the looming possibility of a recession starting later in 2023, could slow Schwab’s growth and prevent it from reaching its expected price targets.

Is Schwab Stock Undervalued?

While there are certain risks that could slow Schwab’s growth and weaken its value argument, the company remains dominant within its industry. Given this fact and its excellent profitability, the bull case for Schwab appears to be stronger than the bear case.

This is particularly true for income-focused investors. Even if earnings growth proves slower than expected, Schwab will still likely be able to continue raising its dividend steadily over the next several years. As such, current pricing may present dividend growth investors a good opportunity to lock in a lower cost basis.

Ultimately, Charles Schwab appears to be an extremely solid business with good growth prospects that is trading at a decent discount to its intrinsic value. Even if earnings growth doesn’t proceed at the expected pace, Schwab seems to be what Warren Buffett might refer to as a wonderful business at a fair price. For value and dividend growth investors, Charles Schwab appears to be a good stock to consider while prices remain low.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.