What Is The Downside To Charles Schwab’s Stock If Interest Rates Remain Steady Due To Recession Fears?
Charles Schwab (NYSE: SCHW) performed strongly in 2018 thus far, with over 17% growth in revenue and a nearly 50% jump in its earnings. Interest earning assets continued to be the primary growth driver, aided by the Fed’s interest rate hikes. Despite this, the stock is down about 20% over the year largely due to the growing concerns about the direction of the market and the possibility of a recession.
We estimate that Schwab’s Interest Income accounts for around 65% of its valuation, slightly over 13x the value contribution of its trading commissions. We have created an interactive dashboard – Schwab’s Sensitivity To Interest Rate Fluctuations – that details how changes in net interest yield can impact Schwab’s share price. You can modify these assumptions to see their impact on the company’s valuation.
Our price estimate for Charles Schwab’s stock stands at $57, which is significantly above the current market price.
Net Interest Yield
Schwab’s net interest yield is heavily dependent on market interest rates. Following the effect of the economic downturn, the interest yield declined over the years to as low as 1.6% in 2015. The yield gathered momentum as a result of the Fed’s interest rate hikes in recent years, due to improvement in the U.S. macro conditions, and reached approximately 2.3% as of September 2018. We forecast this yield to reach around 2.37% by 2019 as we expect the U.S. non-revolving consumer credit to see growth going forward driven by improving economic conditions. However, amidst recession fears, if the interest rate hikes take longer than expected, and the net yield only rises to about 2.27% during the same timeframe (Interest Rate falls by 10 bps), keeping the assets the same as the base case, there would be a downside of 10% to our price estimate, but still well ahead of the current market price. Alternatively, if the market enters a bearish market and the net yield falls further to 2.07% (Interest Rate falls by 30 bps), keeping the assets in line with the base case, there would be a further downside of nearly 22% to our price estimate, but still slightly ahead of the current market price.
By reducing the interest rate by 30 bps, our forecasts for Schwab’s total revenues would decline by about 7%. This results in a total revenue forecast of $10.6 billion for 2019, compared to our base case forecast of $11.45 billion. Our downside forecast for 2019 net income stands at $3.5 billion, versus $3.8 billion in our base case. Given the reduced growth forecast, we have also reduced our P/E multiple in the downside scenario to 17x from a base case of 20x. These changes result in a downside price estimate of $45 for Schwab’s stock. This downside estimate is around 22% below our base case, but still slightly ahead of the current market price. So even in a downside scenario for Net Interest revenue, Charles Schwab still appears to have some modest valuation upside.
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