Online Brokers Worth a Look Amid Pricing Battle

Michael Wong: Investment services firms, such as wide-moat Charles Schwab, narrow-moat TD Ameritrade, and narrow-moat E-Trade, have recently been in the headlines after many of the leading firms decreased their pricing on multiple types of online trade orders to $0. When Charles Schwab made its pricing-change announcement, the share prices of major online brokerages decreased between 10% to around 25%. After adjusting our models for the loss of commission revenue, our fair value estimates generally decreased less than the share prices had fallen--about 5% to 15%. The main reason that our fair value estimates didn't decrease as much as their share prices is because the market seemed to be pricing the stocks off of the change to near-term earnings, while our fair value estimates are based more on long-term earnings. We had also already been forecasting a decline in commission-trading revenue as a percentage of total revenue before the announcements.

After the commission-pricing cuts, leading online brokerages are still highly profitable with operating margins likely to remain in the mid-30s to 40s, even as the companies face likely earnings headwinds related to interest rates and further competition.

Investors can consider looking at these companies for different reasons. We assess Charles Schwab as having the strongest competitive position due to its scale, diversification, and vertically integrated business model. TD Ameritrade currently has the most upside to our long-term fair value estimate, while E-Trade may have the highest near-term upside if other financial-service firms look to merge with it to gain its valuable retail-trader relationships and employee stock plan administration business.