Schwab Loves a Steeper Yield Curve as Net Interest Income Climbs on Higher Rates

by Trefis Team
Charles Schwab
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Online brokerages like Charles Schwab Corporation (NYSE:SCHW) rely significantly on net interest income as a source of value. Schwab competes with firms like E-Trade (NASDAQ:ETFC), Ameritrade (NYSE:AMTD), Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC). As interest rates fall, the net interest earned by assets falls as the company earns a lower interest rate on assets in its possession. During the financial downturn, the net interest rate on loans and securities declined to 1.7% in 2009 from a high of 4.6% in 2007. As the markets recover, we expect Charles Schwab’s income on interest rates will rise in the coming years given adding a nice boost to the business.

While we anticipate Charles Schwab’s interest rate on deposits, loans and securities will reach closer to 4% by the end of Trefis forecast period, Trefis members expect the rate will be around 4.3%, suggesting an upside of almost 5% to our price estimate for SCHW stock. If its net interest rates reached around 5%, this would imply a $22.50 price estimate and 20% upside. This demonstrates how reliant this business is on net interest income which we estimate accounts for over 50% of Schwab’s value.

We currently have a Trefis price estimate of $19.89 for Charles Schwab’s stock, about 5% above the current market price of $18.65.

Consolidation of Banking Industry

Reducing competition could potentially give banks and brokerages the ability to decrease the net interest yields, as volume growth offsets the decline in net interest income. A decrease in competition in the banking system leads to higher spreads as there are less financial institutions who are available to extend loans, thus being in a position to charge higher interest rates.

Costs of Borrowing Expected to Rise

Schwab’s cost of borrowing depends primarily on the interest that it pays out on deposits from banking clients, payables to brokerage clients, and its corporate debt. The average interest that Schwab pays on these sources of financing is primarily dependent on the overall Federal Funds Rate which has been targeted at 0% – 0.25% since December 2008. In comparison, the Federal Funds Rate was mostly recently at a high of 5.25% in June of 2006 and 6.5% in May 2000 with the rate reaching a low during the intervening period of 1% in June 2003. Based on the history of the Federal Funds Rate and long-term expectations for economic recovery, we expect that the Federal Funds Rate will rise to near historical averages and that Schwab’s borrowing costs will increase.

Trefis Community Forecast

Trefis members forecast Charles Schwab’s net interest income rate on deposits, loans and securities will increase from 2.3% in 2011 to 4.3% by the end of the Trefis forecast period, compared to the baseline Trefis estimate of an increase from 2.2% to just about 4% during the same period.  This implies a slight upside of 5% from our current estimates; however additional upside exists if net interest rates climb to historical levels of closer to 5%.

See our complete analysis for Charles Schwab’s stock.

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