Friday, January 11, 2013

Wells Fargo's 2012 Results

Prior to the financial crisis, Wells Fargo's (WFC) book value per share and earnings per share was as follows:*

Book value per share: $ 14.1
Earning per share: $ 2.47

Wells Fargo 2007 Annual Report

Those numbers reflect what was at or near the peak of the company's financial performance before the financial crisis.

So they hardly represented normalized earnings over a full business cycle.

Roughly five years later, those numbers are as follows:

Book value per share: $ 29.5
Earnings per share: $ 3.36

Wells Fargo Full Year and 4th Quarter 2012 Results

Book value per share is up 110% in five years. For many reasons, an imperfect measure of value but, within limits, still a useful proxy.**

Earning per share is up by 36% since the pre-crisis peak. Hardly explosive earnings growth over a five or six year period but, in the context of what has happened to the financial system since 2007, that's a pretty solid business performance from a bank. Of course, what matters more is what Wells Fargo does from here and the valuation.

For continuing long-term shareholders, as long as the business itself continues to perform well (that earnings continue to increase and for a very long time), the lower the normalized earnings multiple remains the better.

Other than a recession or another crisis, it'll be surprising if Wells doesn't continue to improve per share earnings. There's no way to know, of course. The next time the bank's earnings get temporarily reduced due to an economic downturn it's likely to become more valuable as a result. Much as it did in the most recent crisis.

Earnings is often temporarily and depending on the business, even substantially, reduced during a period of reduced economic activity. Stock prices, of course, usually follow. Yet, the fact is a good business often improves during an economic downturn. The strong become stronger. Intrinsic value is actually increased. So, in some cases, price will be moving precisely in the opposite direction of business value even though it doesn't seem so based upon the near-term earnings decline.

If Wells Fargo's share price were to remain near 10x normalized earnings (not peak nor crisis level earnings) or, better yet even less, any buybacks that occur should improve underlying returns nicely for continuing long-term shareholders.

Wells has had a pretty good five years or so but, like many banks, it raised capital during the financial crisis.

Unlike many banks, Wells was able to increase its per share intrinsic value despite the capital that was raised and resulting dilution. Some other banks will not equal pre-crisis per share earnings levels for a very long time, if ever.

Those capital raises certainly had an adverse impact on shareholders to the extent that the market price of common shares were sold below per share intrinsic value. Yet, the cost was modest compared to the increase in Wells Fargo's intrinsic value (and especially modest compared to what happened to some other large financial institutions). In my view, shares of Wells Fargo were sold below the bank's per share intrinsic value, but not so much so that it did huge economic damage to long-term owners. It's the shareholders of those banks that were forced to sell lots of shares (relative to existing share count) and at a very low price  that were hurt badly. Some of those same banks were also forced to sell off valuable businesses.

Sometimes a stock will drop in price because the mood has changed yet per share business value has not (or at least has not nearly as much as the price would indicate). It's psychological factors that determine near-term price action not necessarily changes to real business value.***

Sometimes a stock goes down because real business value per share has been destroyed.

When the former happens, it's a good thing as long as capital does not have to be raised while the shares are selling below intrinsic business value. That's what happened to many banks and, for many of them, it was probably more than well-deserved.

When the latter happens, the result is permanent capital loss or, at least, severe underperformance as business value "catches up" to the price paid over time.

It's not difficult to understand why those with a shorter time horizon react negatively to a drop in price. Otherwise, the reduced share price of a sound business due to primarily to near-term psychological factors is a very good thing for long-term owners.

Why Buffett Wants IBM's Shares "To Languish"

At least it is for a well-financed business with durable competitive advantages. The business with an earnings stream that's persistent (even if somewhat cyclical)  and, better yet, nicely increasing over time. The mistake of letting price action influence one's view of the underlying business is an easy one to make. Learning to ignore the daily quotes does take more than a little discipline.

It's correctly judging the underlying business prospects and whether the price paid provided a sufficient margin of safety that generally matters in the long run.

Adam

Long position in WFC established at much lower than recent market prices

* The peak book value per share number is from 2007. The bank's peak earnings of $ 2.47/share is a 2006 number.  In 2007, the bank earned $ 2.38/share. That drop was likely a small but early indication of the financial crisis yet to unfold.
** Some might prefer using tangible book value per share. On that measure, the increase in tangible book value per share has been an even greater percent over the past five years.
*** Usually grounded by real fundamental issues, but the price movements often end up being far greater, both on the upside and downside, than is warranted. Intrinsic business value just doesn't usually change all that quickly.
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