Charles Schwab Stock Has Limited Upside

Charles Schwab stock (NYSE: SCHW), the largest brokerage firm in the U.S., gained roughly 37% – increasing from about $53 at the beginning of 2021 to around $73 currently, outperforming the S&P500, which grew 13% over the same period. The brokerage giant has surpassed the consensus estimates over the last two quarters, mainly driven by considerable growth in total client assets and brokerage accounts. Further, the company has seen a significant surge in new clients and daily trading activity over the recent months. This has led to positive investor interest in the stock.

There were two main reasons for this growth: First, the approval of the $1.9 trillion stimulus package. Second, increased retail investor participation.

But is this all there is to the story? 

Not quite, despite the recent gains, Trefis estimates Charles Schwab’s valuation to be around $76 per share – slightly above the current market price, based on a key opportunity and one risk factor.

The opportunity we see is an improved trajectory for Charles Schwab’s revenues over the subsequent quarters. The company reported $11.7 billion in revenues for the full year 2020, which is 9% ahead of the 2019 figure. All of this growth was derived in the fourth quarter of 2020, where the company posted a 60% y-o-y increase in revenues. It was due to the completion of the TD Ameritrade acquisition at the start of October 2020, creating a brokerage behemoth. SCHW trading revenues benefited from higher trading activity in the market and increased retail investor participation. Further, its asset management revenues grew 8% y-o-y driven by higher Assets under Management (AuM) – AuM increased 11% y-o-y to $1.97 trillion. That said, this was partially offset by a 6% y-o-y drop in its net interest income (NII) due to the lower interest rate environment.

The company reported significant growth in the first quarter FY2021 – net revenues jumped 80% y-o-y to $4.7 billion. The increase was mainly due to 22% growth in NII coupled with a more than 5x jump in trading revenues. While the NII primarily benefited from higher interest-earning assets as a result of the TD Ameritrade acquisition, partially offset by interest rate headwinds, trading revenues gained from an increase in daily average trades to 8.4 million. On the flip side, trading volumes are expected to normalize with recovery in the economy. But it is likely to take some time. Overall, we expect the SCHW revenues to touch $18.1 billion in FY2021 – 55% more than the 2020 figure.

The adjusted net income margin is likely to see some improvement in the year due to higher revenue growth. As a result, the company’s net income is likely to grow 69% y-o-y to $5.1 billion, leading to an EPS of $3.66. The EPS of $3.66, coupled with the P/E multiple of just below 21x will lead to a valuation of around $76.

Finally, how much should the market pay per dollar of Charles Schwab’s earnings? Well, to earn close to $3.66 per year from a bank, you’d have to deposit about $366 in a savings account today, so about 100x the desired earnings. At SCHW’s current share price of roughly $73, we are talking about a P/E multiple of around 20x. And we think a figure closer to 21x will be appropriate.

That said, brokerage and asset management is still a risky proposition. While growth is likely, change in current market sentiment can harm the near-term outlook. What’s behind that?

Securities markets have seen a spike in trading volumes over the recent quarters. It is also evident from the significant increase in SCHW’s daily trading volume in the first quarter of FY2021. This spike was mainly driven by higher retail investor participation in the market – the company added 3.2 million new brokerage accounts in the quarter. While retail investor participation has significantly increased, it is also to be noted that they don’t have much loss-taking capacity. Hence, a sudden course correction in the market can result in considerable losses for them, pushing them out of business, and hurting the company’s top-line. Additionally, any further deterioration in the economy can lead to a drop in asset valuations, negatively impacting the asset management revenues. To sum things up, we believe that Charles Schwab stock is slightly undervalued. 

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