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

Charles Schwab SCHW reported first-quarter earnings on April 15. Here’s Morningstar’s take on the earnings report and outlook for Schwab’s stock.

Key Morningstar Metrics for Charles Schwab

• Fair Value Estimate: $73.00
• Morningstar Rating: 3 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

What We Thought of Charles Schwab’s Q1 Earnings

• There were clear signs of Schwab’s positive medium-term earnings narrative in its results.
• The firm saw its first increase in revenue since the third quarter of 2022. The increase indicates a trend that should manifest more strongly over the next one or two years of Schwab paying down high-cost funding sources, improving net interest income. We’re still waiting for low-cost transactional cash to materially increase. Results were in line with our outlook.
• The company’s capital levels improved. However, the recent increase in the 10-year Treasury bond could increase losses on fixed-income securities this quarter.
• Client asset inflows recovered from the previous two quarters, which were relatively low.

Fair Value Estimate for Charles Schwab Stock

With its 3-star rating, we believe Schwab’s stock is fairly valued compared with our long-term fair value estimate of $73 per share. Our fair value estimate implies a price/2025 earnings multiple of about 22.5 times and a price/book multiple of about 3.7 times. We made many adjustments to our prior model, with the most impactful change being in our long-run forecast operating margin for the company.

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 even exceed 20%. We also estimate that over 20% of client assets are in either a Schwab proprietary or a controlled product, letting the company 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 lets them 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 that are less sensitive to interest rates than traditional banking customers, and catering to generally higher-net-worth clientele with collateralized lending products.

We think the company’s massive scale gives it a cost advantage that few can match. At the end of 2023, Schwab supported over $8 trillion of client assets, making it one of the largest US-based companies focused on securities trading and wealth management. Its cost advantage can easily be seen with its industry-leading expenses per dollar of client assets, which is often 15 basis points or lower.

Read more about Charles Schwab’s moat rating.

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%.

We assess Schwab has access to enough liquidity and cash. 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%.

Schwab increased its quarterly dividend to $0.25 per share from $0.22 in January 2023. The company targets a dividend payout ratio of 20%-30%. We believe the company will keep this ratio near the lower end of its range and reduce share repurchase activity for the next two years or so as it retains earnings to bolster its liquidity and prepare for changes in bank capital regulations. As the bank grows, we believe the company will periodically issue preferred stock to supplement its regulatory bank capital ratios.

Read more about Charles Schwab’s financial strength.

Risk and Uncertainty

Given the competitive dynamics in the investment services industry, loss of deposits, the future path of monetary policy, the effects of the bear market, and large potential variation in normalized operating margins, we assign Schwab a High Uncertainty Rating. Major risks 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 must remain high for it to fully reprice. In a recession with accommodative monetary policy, portions of the company’s investment portfolio could be stuck at a lower rate. Even if the recession is short-lived, long-term interest rates have generally declined 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 its floating-rate securities.

Read more about Charles Schwab’s risk and uncertainty.

SCHW Bulls Say

• Schwab is solidifying its position as a leader in investment services, and it may be able to expand into other financial services.
• Merging with TD Ameritrade will come with material revenue and expense synergies that will be realized over the next few years.
• Schwab’s scalable and vertically integrated business model should enable it 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

• A loss of deposits and higher funding costs are potential near-term negatives.
• While Schwab has the resources to adapt, financial technology innovation has increased recently and could disrupt parts of the investment services industry. $0-commission business models and robo-advisors are recent trends that challenged the status quo.
• A Europe- or 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.