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

Charles Schwab SCHW is set to release its first-quarter earnings report on April 15. Here’s Morningstar’s take on what to look for in Schwab’s earnings and the outlook for its 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

Earnings Release Date

• Monday, April 15, before the start of trading

What to Watch for In Charles Schwab’s Q1 Earnings

• Key areas remain cash sorting, transactional deposits, and the paydown of high-cost liability balances (certificates of deposit and Federal Home Loan Bank borrowings).
• Cash sorting significantly slowed in the back half of 2023 compared with the first half, and we expect it to remain low. There was some uptick in low-cost transactional cash at the end of 2023, and it will be interesting to see whether transactional cash continued to increase in the first quarter.
• Schwab’s management and other investment service firms cautioned that there may be a seasonal increase in cash balances at the end of the year, and that a rebalancing of client portfolios and payment of taxes could decrease cash early in the year. In the near term, the decrease in high-cost liability balances should have a greater effect on the firm’s earnings than the eventual decrease in the federal funds rate that the market anticipates.
• Schwab expected to hold expenses roughly flat in 2024, so we’ll also look at this area. Material growth in the expense base would be disappointing.

Fair Value Estimate for Charles Schwab

With its 3-star rating, we believe Schwab’s stock is fairly valued compared with our long-term fair value estimate, which we’ve adjusted to $73 per share. That 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 forecasted operating margin for the company.

2024 is a transitional year for Schwab. In its winter business update, the firm laid out “illustrative financial outcomes” ranging from negative 6% to 6% revenue growth. We currently forecast 2024 revenue to be about flat compared with 2023, though higher than the fourth quarter of 2024 run rate. We believe the main driver of the company’s performance in the next one to two years will be how fast it can reduce its high-cost Federal Home Loan Bank borrowings and certificate of deposit balances. In the wake of Schwab reducing these balances and resuming core deposit growth, we forecast earnings will grow at double-digit percentage rates for the foreseeable future.

Read more about Charles Schwab’s fair value estimate.

Economic Moat Rating

We award 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 its 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, letting the company extract more profits on client assets than other brokerages whose clients primarily use third-party products.

Read more about insert company’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 common and preferred dividend payments. Management’s target is a long-term debt/financial capital ratio of no more than 30%.

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

Read more about financial strength.

Risk and Uncertainty

Major risks to Schwab include the future of interest rates, a potential 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 its portfolio, rates must remain high for it to fully reprice. In a recession with accommodative monetary policy, portions of the investment portfolio could be stuck at a lower rate. Even if a 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 rates like the federal-funds rate will affect its floating-rate securities.

While we believe 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 will likely be more because of 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 insert company’s risk and uncertainty.

SCHW Bulls Say

• Charles Schwab is solidifying its leading position 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.
• Schwab’s scalable and vertically integrated business model should let it 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 continued 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 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 Diana Anghel.