A High-Quality Stock to Buy That’s More Than 30% Undervalued

One of the top deposit gatherers in the United States, wide-moat Wells Fargo WFC is in the midst of a multiyear turnaround. Trading more than 30% below our fair value estimate, the bank is among our analysts’ favorite 33 undervalued stocks for the fourth quarter and one of Morningstar chief U.S. market strategist Dave Sekera’s three undervalued stocks to buy this quarter. Wells also lands on our list of the 10 best companies to invest in for October.

Wells Fargo remains in rebuilding mode. The bank is still under an asset cap imposed by the Federal Reserve, and we don’t see this restriction coming off soon. It has years of expense saving-related projects ahead as it attempts to get its efficiency ratio back under 60%. We also see a multiyear journey of repositioning and investing in Wells’ existing franchises, including increasing its middle-market investment banking share, investing in the cards franchise, and revitalizing a wealth segment that has lost advisors for years. These tasks take on increased importance for a bank that has been on defense for years after its fake accounts scandal broke in late 2016. We’re starting to see glimpses of the transition to offense from defense, but Wells has a ways to go.

Key Morningstar Metrics for Wells Fargo

• Fair Value Estimate: $61
• Star Rating: 5 Stars
• Economic Moat Rating: Wide
• Uncertainty Rating: Medium

Economic Moat Rating

We believe Wells Fargo possesses a wide moat based on cost advantages and switching costs. Wells Fargo is one of the largest U.S.-based banks by assets and has leading share and operations in many of the key areas in which it competes. It has one of the largest retail branch networks in the U.S. and is one of the leading deposit gatherers in the country. It is also one of the largest U.S. issuers of credit and debit cards, has one of the leading commercial banking franchises, has a leading consumer franchise with products across roughly 70 million consumers and small businesses, and also has significant wealth-management operations with its advisory unit. We believe Wells will consistently earn returns that exceed its 9% cost of equity through the cycle.

Read more about Wells Fargo’s moat rating.

Fair Value Estimate for Wells Fargo Stock

Our $61 fair value estimate is equivalent to 1.7 times reported tangible book value per share as of March 2023, or 1.6 times excluding accumulated other comprehensive income. We do not have the bank breaking the asset cap barrier until after 2024; this could turn out to be conservative, but it is very difficult to know for sure. We foresee minimal earning asset growth until then, although we do project some shift from cashlike assets into loans over time. We project interest rates will fall in 2024 and 2025, leading to net interest income declines of 5% and 2%, respectively. We then expect NII will grow from there with the balance sheet. We expect essentially flat core expenses in 2023 and a small net decline in 2024. Our base-case expectations produce a terminal return on tangible equity of roughly 12%-13%, in excess of the bank’s 9% cost of equity and a bit below management’s 15% long-term target.

Read more about Wells Fargo’s fair value estimate.

Risk and Uncertainty

An investment in Wells Fargo entails a large amount of regulatory and macroeconomic risk. For Wells, the cost of compliance is high. The bank is large and complex and is a prime target of regulators and litigants. Also, its profitability will be materially affected by the interest-rate cycle and the effects of credit and debt cycles, all of which are not under management’s control. Most lines of business at Wells are economically sensitive. In addition, the bank is subject to the Federal Reserve’s annual stress test. If Wells were required to hold more capital, returns on equity could be affected. Because the company is in turnaround mode, there is also higher operational risk.

Read more about Wells Fargo’s risk and uncertainty.

Wells Fargo Bulls Say

• Wells Fargo has some of the highest rate sensitivity of the Big Four U.S. banks. An inability to expand the balance sheet means even lower deposit betas and larger net interest margin expansion, giving it an extra earnings boost as rates rise.
• Wells Fargo’s retail branch structure, advisory network, product offerings, and share in small and medium-size enterprises are difficult to duplicate.
• Wells should have several years left of slower expense growth while a big regulatory catalyst—the lifting of the asset cap—remains.

Wells Fargo Bears Say

• Wells Fargo still has consent orders outstanding, including the asset cap, and has been on defense for years, raising the potential for structural damage to its competitive positioning.
• With the asset cap remaining, Wells will be unable to materially expand its balance sheet, a headwind to earnings growth.
• There are few positive catalysts left for banks. Funding costs are running higher, net interest income has probably peaked, higher regulatory scrutiny is likely, and a recession may be around the corner.

This article was compiled by Susan Dziubinski and Sylvia Hauser.