Tuesday, January 22, 2008

An Inverted Look At Wells Fargo

Wells Fargo currently has a market capitalization of around 87 billion, and ten year US Treasuries yield 3.44%. Let's say we wanted our investment in Wells Fargo to have worst-case, a 5 percent earnings yield on a very solid franchise. Then Wells Fargo would need to generate a minimum income of 5% x 87 billion, or 4.35 billion. And there is one more thing: We want to work with before-tax numbers, so adjusting for that means we want a minimum of 6.69 billion in operating income per year.

Now we can look at their most recent earnings report and see what level of losses they can handle while still giving us that minimum return. In their most recent quarter, they generated:

(numbers in millions)
9,242 interest income
-3,754 interest expense
= 5,488 net interest

+4,500 non-interest income (rounded down from 4717)
-5,900 non-interest expense

=4,088 quarterly earnings before credit provision and tax

We would need 1,673 million in quarterly operating income, so we can provision 2.4 billion a quarter while still earning a 5% earnings yield on a Wells Fargo common stock.

This means they can provision 9.64 billion a year, which is 2.52% in yearly charge offs. (Remember this is charge-offs, which is after recoveries from the sale of collateral) For comparison, Wells Fargo most recent quarter had an annualized loss rate of 1.28%, and going back to 1988 the worst rate was 1.66%.

So is this a market overreaction? This analysis does assume two things. First, that interest spreads between assets and deposits remain the same. With the recent interest rate cuts, it is likely that net interest margins will contract for financial institutions going forward. Second, it assumes company assets remain constant. Wells Fargo has a very long history of expanding assets, and factoring in future growth would result in a large boost to valuation. But near term a decline seems more likely, as wealth starts to disappear and place considerable stress on economic money supply. If things get really bad, then a sharp drop in assets is plausible from today's levels. These are two things I am still trying to get comfortable with before making my decision, but others might enjoy this fresh look for investing in financials.


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