URI Capital Partners opened in August of 2012. JP Morgan has been a large holding since the fund opened and continues to be a large holding today. JP Morgan has risen in price from around $37 at our initial purchase to over $55 today. This investment thesis is meant to recalibrate the relation of price and value as it stands in April of 2014 for JP Morgan.
To set the perspective of our approach to investing, our goal is to acquire stakes in world class companies at a discount to a consistently increasing intrinsic value, allowing for strong future returns with limited risk of permanent capital loss.
Our ideal investment would entail buying (1) a great business run by (2) superb management at (3) a low valuation. The business should also be timeless, understandable and should retain an ability to compound returns for years into decades with minimal tax drag. When we can invest in a great business run by world class managers at low valuations, we invest aggressively.
JP Morgan is one of the leading global financial services firms with businesses including consumer and community banking, corporate and investment banking, commercial banking, and asset management. JP Morgan is also a company that can feel incredibly uncomfortable to invest in today which makes it worthy of further study and potential investment.
How Should JPM Be Valued?
Part of the challenge in valuing and in some ways understanding JP Morgan stems from its breadth of businesses. Is JP Morgan a traditional bank? An investment bank? An asset manager? The short answer is all of the above and therein lies part of the complication.
JP Morgan earned an adjusted $5.70 per share in 2013. Tangible book value at the end of 2013 was $40.81 and if we assume it can earn 15% on that tangible equity it would earn roughly $6.12 per share this year. Analyst estimates for 2013 earnings are in the neighborhood of $6 per share with a fair amount of variability. JP Morgan trades in the neighborhood of $55 as of this writing.
What is a fair multiple or earnings to pay? The multitude of businesses inside JP Morgan makes this already difficult question even more difficult than usual. To paint the extremes of its business from a valuation perspective, we should be willing to pay a much higher multiple of earnings for the recurring and reasonably steady earnings from asset management when compared to the more volatile investment banking business. We must start somewhere however so ascribing a 12x multiple to the entire franchise seems a reasonable start and a discount to historic norms. Ascribing that 12x multiple to a $6 per share earnings figure implies value of $72 per share. If we assume the business is now boring and “utility” like then a fair multiple would be much higher. I do not share that opinion but you cannot call a business boring and utility like and then value it at 10x or 12x earnings, particularly when large plants and equipment are not required for growth.
While $72 seems reasonable for the earnings being generated today, I still believe it misses some of the underlying value that exists in the business. JP Morgan is not earning to its potential today largely due to the current low rate environment. Net interest margin moving from 2.2% to 2.7% (still below historic averages) alone brings earnings to about $7.60 on today’s share count. That net interest margin potential is on the balance sheet today but again is largely obscured by low rates. A 12x multiple of $7.60 brings value to over $90. Interest rates will not rise to make that possible in the short term however, so some discount to that value is warranted to determine value today.
So, how can we think about growth and value going forward? Tangible book value per share has grown around 12% on average per year since 2005. Growing by a lesser 10% per year would bring tangible book value per share to roughly $65 in 2018. A return of 15% on tangible common equity would thus yield earnings of roughly $9.40 for 2018 (using a rough average of estimated 2017 and 2018 year end tangible book values). If during 2018 that $9.40 is valued at 12x it would bring a share price of roughly $112.
How should we discount that price back to today? Assuming that $112 is four years from now (assuming 12x current year 2018 earnings roughly midway through 2018) we can ascribe different discount rates to bring us back to today. At a 10% discount rate, a today value would be around $76.At a 7.5% discount rate, a today value would be about $83.
Thinking of value another way, what is a fair multiple of tangible book value to pay? Tangible book value was $40.81 at the end of 2013 and increased to $41.73 in the first quarter of 2014.To earn a 7.5% return today (that should grow relative to original cost as tangible book value and thus dollar returns grow over time) you could pay up to 2.0x tangible book value, or $83. Investors are obviously not inclined today to pay 2.0x tangible book for a large bank but through history there has been strong willingness to do so.
During Investor Day, JP Morgan’s CFO Marianne Lake seemed to imply the company was good value up to 2.0x tangible book. The weight of this must be small given the lack of depth behind the statement but it does serve as a small dose of support for the other values discussed above.
As can be seen, there are many paths to determining a fair price for JP Morgan and none can be done with precision so that is why we have spoken of a number of different methods and outcomes. With that in mind however, all of the above valuation scenarios allow for a wide margin of safety with significant upside given today’s $55 price.
And while JP Morgan has significant earnings power, those earnings will be lumpy and thus difficult for more short sighted investors. For those with a long term perspective however, the opportunity to buy JP Morgan at today’s prices remains unique.
Many investors have continued to avoid the large money center banks and their valuations reflect such avoidance and JP Morgan even more so than the others. Do these low valuations reflect the turbulences of yesterday, or tomorrow? I would argue rear view mirror assessment on the headline inducing challenges facing JP Morgan is too prevalent and does not properly account for the earnings power of the franchise.
JP Morgan currently generates a tremendous level of earnings set against a heavily discounted valuation all with significant upside earnings potential as the lending environment normalizes. JP Morgan is great value today and even greater as we look forward.
World class company. World class management. Discounted valuation.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.