After Earnings, Is Charles Schwab Stock a Buy, a Sell, or Fairly Valued?

Charles Schwab SCHW reported second-quarter earnings on July 16. Here’s Morningstar’s take on the report and its outlook for Schwab’s stock.

Key Morningstar Metrics for Charles Schwab

• Fair Value Estimate: $76.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

What We Thought of Charles Schwab’s Q2 Earnings

• Schwab reported some disappointing results. After revenue increased in the first quarter, investors may have thought the firm had turned the corner and revenue would be on a sustainable uptrend. However, it took a step back instead. Some high-cost funding sources, such as certificates of deposit and Federal Home Loan Bank borrowings, increased in the quarter, another slight reversal of positive trends.
• The company discussed using third-party bank agreements for client cash and deemphasizing putting client cash in its own bank, counter to general industry trends.
• There’s increased uncertainty over pricing pressures for sweep cash accounts, either for competitive, lawsuit, or regulatory reasons.
• Scwhab’s medium-to-long-term earnings growth story largely depends on low-cost client cash levels stabilizing. Given that the federal funds rate is likely going lower over the next several quarters, we expect relief in the “cash sorting” behavior pressuring client cash levels.
• Before the company reported earnings, it traded at about our fair value estimate of $76 per share. Some additional uncertainty is being reflected in the stock price, and because of that, we believe shares look more attractive.

Fair Value Estimate for Charles Schwab Stock

With its 4-star rating, we believe Schwab’s stock is undervalued compared with our long-term fair value estimate of $76 per share, which implies a price/forward earnings multiple of about 21 times and a price/book multiple of about 4.4 times. In the medium term, we forecast a 9.5% compound annual growth rate for net revenue as trading revenue flattens, client assets increase at an 8% rate, and deposits increase after cash sorting subsides and certificate of deposit balances are allowed to run off. Much of the revenue growth is attributable to net interest income from the resumption of deposit growth and reinvesting of maturing fixed-income proceeds.

Read more about Charles Schwab’s fair value estimate.

Economic Moat Rating

We assign Schwab a wide moat. Given its massive scale and industry-leading cost efficiency, we believe the company could endure severe competitive pressures and still earn above its cost of capital. After the company’s commission pricing cut in 2019, we still forecast returns on capital in the low-to-mid-teens, well above its cost of capital, which we estimate in the high single digits. In the long run, we believe returns on invested capital could exceed 20%. We also estimate that over 20% of client assets are in either a Schwab proprietary or a controlled product, allowing the company to extract more profits on client assets than other brokerages whose clients primarily use third-party products.

We think the company’s massive scale gives it a cost advantage that few can match. At the end of 2023, Schwab supported over $8 trillion of client assets, making it one of the largest US-based companies focused on securities trading and wealth management. Its cost advantage can easily be seen with its industry-leading expenses per dollar of client assets, which is often 15 basis points or lower.

Read more about Charles Schwab’s economic moat.

Financial Strength

We are fairly comfortable with Schwab’s financial health. We believe the firm can shoulder its debt load, cover its interest obligation, and make its common and preferred dividend payments. Management’s target is a long-term debt/financial capital ratio of no more than 30%.

The company can utilize borrowing facilities from the Federal Reserve and Federal Home Loan Bank system by pledging collateral. It also has natural streams of cash from net new client assets, maturing securities, and earnings. We don’t believe market participants will worry about Schwab’s capital position unless the 10-year US Treasury bond rate climbs above 5%.

Schwab increased its quarterly dividend to $0.25 per share from $0.22 in January 2023. The company targets a dividend payout ratio of 20%-30%. We believe it will keep this ratio near the lower end of its range and reduce share repurchase activity for the next two years or so as it retains earnings to bolster its liquidity and prepare for changes in bank capital regulations. As the bank grows, we believe the company will periodically issue preferred stock to supplement its regulatory bank capital ratios.

Read more about Charles Schwab’s financial strength.

Risk and Uncertainty

Given the competitive dynamics in the investment services industry, loss of deposits, the future path of monetary policy, the effects of the bear market, and large potential variation in normalized operating margins, we assign Schwab a High Uncertainty Rating. Major risks include the future of interest rates, a decrease in deposits, and fee pressures.

Interest rates are a key driver of the company’s earnings over the next several years. Due to the staggered reinvestment of the company’s portfolio, interest rates must remain high for it to fully reprice. In a recession with accommodative monetary policy, portions of the company’s investment portfolio could be stuck at a lower rate. Even if the recession is short-lived, long-term interest rates have generally declined for years. Low long-term interest rates will affect Schwab’s reinvestment opportunities for much of its banking portfolio, while short-term interest rates, such as the federal-funds rate, will affect its floating-rate securities.

Read more about Charles Schwab’s risk and uncertainty.

SCHW Bulls Say

• Schwab is solidifying its position as a leader in investment services and may be able to expand into other financial services.
• Merging with TD Ameritrade comes with material revenue and expense synergies that will be realized over the next few years.
• A scalable and vertically integrated business model should enable Schwab to convert an increasing percentage of revenue into earnings and be in the better parts of the value chain as the investment services industry evolves.

SCHW Bears Say

• The potential for a lack of growth in low-cost deposits would be a negative for the firm.
• While Schwab has the resources to adapt, financial technology innovation has increased in recent years and could disrupt parts of the investment services industry. Recent trends like $0 commission business models and robo-advisors are challenging the status quo.
• A Japan-like scenario of near-0% interest rates for an extended period would significantly reduce earnings and likely necessitate a change in business model. The Fed may have to lower interest rates if a recession occurs.

This article was compiled by Krutang Desai.