Wells Fargo Is A Buy Despite All The Uncertainties (NYSE:WFC) – Seeking Alpha

From the beginning of the year to mid-February, Wells Fargo & Company (NYSE:WFC) stock price increased from $50 to $60. Now, the stock’s price is $43. My stock valuation using the free cash flow to equity (FCFE) model indicates that with more than 30% upside potential, WFC is a buy at prices around $45. However, the risks of the ongoing war in Ukraine, the pandemic, and most importantly, the uncertain monetary and fiscal policies of the U.S. Federal Reserve and government, may keep WFC undervalued for now.

1Q 2022 financial results

In its first-quarter 2022 financial results, Wells Fargo reported a net income of $3671 million, compared with 1Q 2021 net income of $4636 million, up 26%. WFC’s revenue decreased from $18532 million in 1Q 2021 to $17592 million in 1Q 2022. Moreover, the company’s noninterest expenses decreased from $13989 million to $13870 million. Wells Fargo’s provision for credit losses (PCL) decreased from $1048 million in 1Q 2021 to $787 million in 1Q 2022. “While we will likely see an increase in credit losses from historical lows, we should be a net beneficiary as we will benefit from rising rates,” The CEO commented.

The company finished the first quarter of 2022 with a $1.1 billion, or 21 cents per share decline in its allowance for credit losses (ACL). The company’s 1Q 2022 average loans increased 2.9% YoY, and its average deposits increased 5% YoY. Also, WFC’s Common Equity Tire 1 (CETI) ratio decreased from 11.8% in 1Q 2021 to 11.5% in 1Q 2022. From 1Q 2021 to 1Q 2022, WFC’s return on equity (ROE) decreased from 10.3% to 8.4% and its return on average tangible common equity (ROTCE) decreased from 12.4% to 10%. Wells Fargo, repurchased 110.1 million shares, or $6 billion, of common stock in 1Q 2022.

Mentioning the Federal Reserve’s plans to reduce inflation (that will certainly reduce economic growth) and additional risks of the war in Ukraine, the CEO claims that Wells Fargo is well-positioned to provide support for its clients in a slowing economy. Furthermore, amid all the challenges, the company partnered with Bilt Rewards and Mastercard to issue the first credit card that earns points on rent payments without a transaction fee.

Performance

To analyze the management’s ability to keep expenses and revenues in check, I consider Wells Fargo’s efficiency ratio and compare it with its peer, Bank of America. Considering WFC’s quarterly efficiency ratio indicates that, in December 2021, the company declined its ratio by increasing its revenue. Thus, WFC’s efficiency ratio at the end of December 2021 decreased by 451 bps, to 61.23%, compared to the quarter that ended in Sep 2021. In the first quarter of 2022, which ended on 31 Mar 2022, WFC’s revenue declined to $18379 million, while its operating expenses were nearly constant. Thus, the efficiency ratio of WFC increased by 1421 bps to 75.44% (see Figure 1).

Figure 1- WFC’s efficiency ratio

Moreover, to investigate if the management could generate profits for shareholders and to analyze the productivity of the bank’s operations, the efficiency ratio is a quick comparison tool between the peers. As it is represented in Figure 2, Wells Fargo’s efficiency ratio dropped by 2840 bps to 64.89% in 2021, compared with its efficiency ratio of 93.29% in 2020. Also, Bank of America experienced a drop from 74.40% in 2020 to 63.74% at the end of 2021. In a word, the efficiency ratios of Wells Fargo and Bank of America have moved in tandem. Their TTM efficiency ratios are 65.71% and 64.55%, respectively (see Figure 2).

Figure 2- WFC and BAC efficiency ratios

Another measurement to analyze the efficiency of the banks is operating leverage. This metric reflects the balance between revenue and expenses growth. After two years of negative operating leverages consecutively, Wells Fargo’s operating leverage increased by 6686 bps to 41.91% at the end of 2021 compared with its previous level of -24.95% at the end of 2020. In 2021, WFC’s revenue grew by 37.6%, while its operating expenses declined by 4.2%. Moreover, Bank of America’s operating leverage reached 18.1% at the end of 2021 after two years of consecutive negative amounts. BAC’s positive operating leverage was produced by revenues growing faster than expenses. Its total revenue grew by 26%, while its operating expenses increased by 8% during 2021 (see Figure 3).

Figure 3- WFC and BAC’s operating leverages

WFC Valuation

Using the FCFE model, I calculate the fair value of WFC. I used two approaches to build my way of using the FCFE model for evaluating bank stocks. According to the first approach of using the FCFE model to evaluate bank stocks, I estimate total assets, total liabilities, Tier 1 ratio, total risk-weighted assets (RWAs), net revenues, and net income of WFC from 2022 to 2032. Also, according to the second approach, I calculate the FCFE of the company

Estimation of total assets growth is one of the main parts of my valuation. From 2012 to 2021, WFC’s total assets increased with a compound annual growth rate of 3.2% to $1948 billion. I used four scenarios to estimate the total assets of WFC from 2022 to 2032. In my base scenario, I expect WFC’s total assets to increase with a CAGR of 3.2 through 2032. With the contractionary monetary and fiscal policies of the US Federal Reserve and government, I expect WFC’s total assets to increase with a CAGR of 2% through 2022. With the expansionary monetary and fiscal policies, I expect WFC’s total assets to increase with a CAGR of 4% between 2022 to 2032. Finally, with the extremely expansionary monetary and fiscal policies, I expect WFC’s total assets to increase with a CAGR of 5% through 2032.

Table 1 shows that from 2017 to 2021, RWAs to total assets ratios of Wells Fargo were between 0.61 to 0.66. Moreover, the company’s capital Tier 1 ratio decreased from 15% in 2017 to 13% in 2021. In the first quarter of 2022, WFC reported a capital Tier 1 ratio of 12%. The company’s CEO said that Wells Fargo is likely to see an increase in credit losses from historical lows. Also, he said that Federal Reserve’s plans to reduce inflation certainly reduce economic growth.

Thus, I don’t see the company increasing its Tier 1 ratio to its pre-pandemic levels. Also, I don’t see the company allowing its Tier 1 ratio to drop to below 10%, as it would be too risky. I used three scenarios for WFC’s capital Tier 1 ratio: 11.5%, 12.5%, and 13.5%. In my base scenario, I estimate a capital Tier 1 ratio of 12.5% for the company from 2022 to 2032 (on average). With a COE of 8.5%, I calculate a fair value of $58 per share for Wells Fargo.

Table 1 – WFC stock valuation using FCFE model

Table 2 shows that according to different scenarios for WFC’s COE, Tier ratio, and total assets growth rate, the stock’s fair value ranges from $51 to $68. However, the probability of the scenarios with a Tier 1 ratio of 11.5% and total assets CAGR of 5% is very low. In some quarters, the company’s Tier 1 ratio may drop to 11.5%; however, on average, from 2022 to 2032, a Tier 1 ratio of 11.5% is not probable. Thus, I narrow the stock’s price fair value down to $51 to $62. According to my base case scenario (Tier 1 ratio of 12.5%, total assets CAGR of 3.2%, and COE of 8.5%), I calculate a fair value of $58 for WFC.

Table 2 – WFC stock valuation based on different scenarios for its total assets growth rate, Tier 1 ratio, and COE

Summary

WFC is undervalued based on different scenarios for its total assets growth rate, Tier I ratio, and cost of equity. Its fair value ranges between $51 to $68. However, I don’t see the company increasing its Tier 1 ratio to its pre-pandemic levels of 14% to 15%. Also, I don’t see the company allowing its Tier 1 ratio to drop below 10%, as it would be too risky. Moreover, the combination of the US Federal Reserve’s actions to control inflation, the effects of the COVID-19 pandemic, and the war in Ukraine determine WFC’s total assets growth rate. In my base scenario, I used a 10-year CAGR of 3.2% to estimate the company’s total assets. WFC is worth $58 per share.

Source: seekingalpha.com