After Earnings, Is Schwab Stock a Buy, a Sell, or Fairly Valued?

Charles Schwab released its third-quarter earnings report on Oct. 17. Here’s Morningstar’s take on Schwab’s earnings and stock.

Key Morningstar Metrics for Charles Schwab

• Fair Value Estimate: $76.00
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

What We Thought of Schwab’s Fiscal Q3 Earnings

• This was the company’s best quarter for revenue and net income since the first quarter of 2023. As expected, there was high growth in client assets and asset prices. We were happy to see a decrease in bank supplemental borrowing balances, which helped improve net interest income. Lowering high-cost funding sources remains the key short-term lever for higher net interest income and earnings.
• We’re still waiting to see a firm stabilization in low-cost deposit balances. Material increases in low-cost client cash balances (in absolute terms and as a percentage of client assets) would also be a major positive.
• Metrics in the quarter supported our investment thesis of higher net interest revenue and revenue in the medium-to-long term from reducing high-cost bank supplemental borrowing balances and eventual growth in low-cost client cash balances. After the recent pop, we believe the company is fairly valued.

Fair Value Estimate for Charles Schwab

With its 4-star rating, we believe Schwab’s stock is undervalued compared with our long-term fair value estimate of $76 per share, which implies a price/forward earnings multiple of about 21 times and a price/book multiple of about 4.4 times. In the medium term, we forecast a 9.5% compound annual growth rate for net revenue as trading revenue flattens, client assets increase at an 8.0% rate, and deposits increase after cash sorting subsides and certificate of deposit balances are allowed to run off. Much of the revenue growth is attributable to net interest income from the resumption of deposit growth and reinvesting of maturing fixed-income proceeds.

Read more about Charles Schwab’s fair value estimate.

Economic Moat Rating

We assign Schwab a wide moat. Given its massive scale and industry-leading cost efficiency, we believe the company could endure severe competitive pressures and still earn above its cost of capital. After the company’s commission pricing cut in 2019, we still forecast returns on capital in the low-to-mid-teens, well above its cost of capital, which we estimate in the high single digits. In the long run, we believe returns on invested capital could exceed 20%. We also estimate that over 20% of client assets are in either a Schwab proprietary or a controlled product, allowing the company to extract more profits on client assets than other brokerages whose clients primarily use third-party products.

Retail brokerages’ moats are primarily built on cost advantages. Their scalable infrastructure allows them to process additional trades at low costs, which produces high incremental operating margins. Many retail brokerages also have banking subsidiaries that rank well compared with traditional banks in terms of low funding costs, credit costs, and operating expenses. Their strong banking subsidiary profitability—recent operating margins have been around 70%—comes from not having to support a physical branch presence, brokerage clients less sensitive to interest rates than traditional banking customers, and catering to generally higher-net-worth clientele with collateralized lending products.

Read more about Charles Schwab’s economic moat.

Financial Strength

We are fairly comfortable with Schwab’s financial health. We believe the firm can shoulder its debt load, cover its interest obligation, and make its common and preferred dividend payments. Management’s target is a long-term debt/financial capital ratio of no more than 30%.

The company can utilize borrowing facilities from the Federal Reserve and Federal Home Loan Bank system by pledging collateral. It also has natural streams of cash from net new client assets, maturing securities, and earnings. We don’t believe market participants will worry about Schwab’s capital position unless the 10-year US Treasury bond rate climbs above 5%.

Read more about Charles Schwab’s financial strength.

Risk and Uncertainty

Major risks to Schwab include the future of interest rates, a decrease in deposits, and fee pressures. Interest rates are a key driver of the company’s earnings over the next several years. Due to the staggered reinvestment of the company’s portfolio, interest rates have to remain high for the investment portfolio to fully reprice. In a recession with accommodative monetary policy, portions of the company’s investment portfolio could be stuck at a low rate. Even if a recession is short-lived, long-term interest rates have been in a generally declining trend for years. Low long-term interest rates will affect Schwab’s reinvestment opportunities for much of its banking portfolio, while short-term interest rates, such as the federal-funds rate, will affect the company’s floating-rate securities.

While we currently believe that nominal long-term interest rates will eventually track back to about 4.5%, structural changes in the economies of developed countries may have permanently reset long-term interest rates lower along with the profitability of Schwab’s banking business. Asset-management revenue could also come under pressure, but it’s likely to be more from an asset mix shift to passive investment products from the company’s proprietary and Mutual Fund OneSource products, which have higher revenue yields.

Read more about Charles Schwab’s risk and uncertainty.

SCHW Bulls Say

• Schwab is solidifying its position as a leader in investment services and may be able to expand into other financial services.
• Merging with TD Ameritrade comes with material revenue and expense synergies that will be realized over the next few years.
• A scalable and vertically integrated business model should enable Schwab to convert an increasing percentage of revenue into earnings and be in the better parts of the value chain as the investment services industry evolves.

SCHW Bears Say

• The potential for a lack of growth in low-cost deposits would be a negative for the firm.
• While Schwab has the resources to adapt, financial technology innovation has increased in recent years and could disrupt parts of the investment services industry. Recent trends like $0 commission business models and robo-advisors are challenging the status quo.
• A Japan-like scenario of near-0% interest rates for an extended period would significantly reduce earnings and likely necessitate a change in business model. The Fed may have to lower interest rates if a recession occurs.

This article was compiled by Frank Lee.