In April, I escorted JP Morgan Chase (JPM) into the Valuation Zone and found that it was undervalued by about 12%.
In May, I did a deep dive into Canadian Imperial Bank of Commerce (CM) as my Dividend Growth Stock of the Month and concluded that it was more than 20% undervalued.
This month, let’s continue the banking theme. I want to bring JPM back and do a complete analysis as this month’s Dividend Growth Stock of the Month. One often hears that JPM is the best-run American bank. Let’s find out for ourselves.
To analyze JPM, I will use the approaches described in DGI Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your Portfolio and DGI Lesson 11: Valuation.
JPM’s Dividend Record
JPM’s dividend record has been getting stronger. The bank, of course, was caught in the financial crisis, and it received a government bailout, even though it has said repeatedly that it did not need one.
Here is how Jamie Dimon, JPM’s CEO, describes that period in the most recent annual report:
Many people still ask me about the Troubled Asset Relief Program (TARP), a government program that provided funding to banks in the midst of the crisis. JPMorgan Chase did not want or need TARP money, but we recognized that if the healthy banks did not take it, no one else could — out of fear that the market would lose confidence in them. And while it helped create the false rallying cry that all the banks needed support, the government, both the Federal Reserve and the Treasury, was trying everything it could in addition to TARP. And the Federal Reserve and the Treasury should be congratulated for the extraordinary actions they took to stave off a far worse crisis. In hindsight, it is easy to criticize any specific action, but, in total, the government succeeded in avoiding a calamity.
JPM cut its dividend during the crisis, held it steady for a year, and then embarked on its 8-year climb. Nothing on the horizon suggests that another cut is coming anytime soon, but it should be noted that the banking industry does seem to have periodic crises.
Here is JPM’s dividend record over the 20 years ending in 2018.
[Image source: Simply Safe Dividends]
JPM’s dividend recovered to its pe-crisis levels in 2014, and it has been steadily growing since then.
In Simply Safe Dividends’ scoring system, JPM gets a dividend safety score of 79/100, meaning that its dividend is rated as safe and unlikely to be cut. For more insight into dividend safety, see Dividend Growth Investing Lesson 17.
JPM’s Business Model and Quality
JPMorgan Chase is one of the oldest financial institutions in the United States, with predecessor banks going back to 1799.
In the USA, JPM is the largest bank by assets, and it is regarded as the most dominant bank given its broad scope of operations in investment banking, commercial banking, credit and debit cards, retail banking, and wealth management.
It has service/product relationships with over 60 million U.S. households.
Globally, JPM serves millions of consumers, small businesses, and many of the world’s most prominent corporate, institutional and government clients.
The company is a leader in investment banking, financial services, commercial banking, processing financial transactions, and asset management.
The following slide sums up JPM’s own views of its business strengths.
JPM has piled up accolades.
- It ranks #1 in U.S. retail deposit growth
- It’s in the Top 10 of Fortune’s World’s Most Admired Companies
- Its digital banking portal ranks #1 in visits
- It has received the most investment banking fees globally for 10 straight years
- Morningstar ranks its Stewardship as Exemplary
Structurally, JPM engages in and separately reports these lines of business:
- Consumer & community banking
- Corporate & investment banking
- Commercial banking
- Asset & wealth management
The following slide summarizes JPM’s performance in each line of business:
[JPM Investor Day presentation]
Reading the company’s annual report is akin to reading a textbook about how banking should be conducted. For examples, the company emphasizes:
- its long-term approach to planning and growth;
- how it endeavors to be the best at everything it does;
- its “fortress” balance sheet;
- its commitments to communities, employees, and customers;
- its commitment to protecting privacy in its digital operations.
Morningstar awards JPM a wide moat based on its sustainable cost advantages and customer switching costs.
Here is a summary of JPM’s business quality rankings:
I like to begin this section by seeing how Value Line rates the company’s financial strength. Then I go through specific financial metrics and see if I agree with their assessment.
Value Line gives JPM its 2nd-highest Financial Strength grade, A+, which it has held since 2017:
Let’s look at some key financial categories and see if we agree.
Return on Equity (ROE) is a standard measure of financial efficiency and is extensively used with banks. ROE is the ratio of profits to shareholders’ equity.
The average ROE for all CCC stocks is 14%, and for S&P 500 companies it is about 13%. The following chart shows JPM’s ROE 2009-2018.
[Source of all yellow-bar graphs: Simply Safe Dividends]
You can see that JPM’s ROE has run a little below average for several years, until 2018, when it jumped into the average range.
Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.
With banks, the D/C metric is not helpful. Banks’ product itself is money, and the low-cost deposits that the bank holds are actually debts that it owes. So D/C typically is not used in analyzing a bank.
The normal use of D/C is to gauge risk and determine how strong the balance sheet is. With banks, regulators measure risk in a variety of ways, but the most basic measure is under a set of international standards called Basel III.
I won’t get highly technical here, but the regulatory goal – especially in the wake of the financial crisis of 2007-2009 – is to make sure that banks have an adequate buffer in place to help ensure their solvency in the event of unexpected events.
We saw earlier that JPM considers itself to have a “fortress balance sheet.” This graphic from JPM’s annual report illustrates what that means and how its balance sheet has improved since the financial crisis.
The headline metric that banks report is their CET1 (common equity tier 1) ratio. The chart below depicts CET1 requirements under Basel III, showing how they have been phased in. Notice that JPM’s CET1 ratio of 12% handily exceeds the regulatory requirement of 10.5%.
JPM has also stated that it believes that it will operate with a Basel III CET1 capital ratio between 11% and 12% over the medium term.
Another clue about a bank’s solidity is its credit rating. JPM has an investment-grade credit rating of A-. S&P describes its “A” level ratings this way:
An obligor rated A has strong capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
Operating margin is normally one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.
Unfortunately, operating margin is not meaningful for banks, because of the role that interest payments play in their complex financial accounting.
When I analyzed Canadian Imperial Bank of Commerce in April, I discovered that they tracked an “efficiency ratio” involving their expenses required to turn revenue into profits.
JPM tracks something similar, also using the word “efficiency” to describe it:
From the above chart, we see that JPM ranks at or near best-in-class with its overhead ratios for all of its lines of business. It is the best in class in commercial banking.
The following chart indicates that overall, JPM has the best (lowest) overhead ratios among the banks that it considers its peers: Citigroup ( C), Bank of America (BAC), Goldman Sachs (GS), Wells Fargo (WFC), and Morgan Stanley (MS).
Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.
That is a nice EPS record. JPM has delivered positive earnings steadily. They have gone up in 8 of the past 9 years.
Free Cash Flow (FCF) is another metric that I usually asses, but again it is not very useful when examining banks. Earnings are a more reliable metric.
Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.
JPM has been slowly reducing its share count for several years. At the end of 2018, JPM’s outstanding shares were 12% fewer than 9 years earlier.
Here is a summary of the items above:
A lot of our normal data points are not meaningful as to banks. In their place, special metrics suggest that JPMs finances are strong.
I find no reason to disagree with Value Line’s A+ financial rating for JPM.
JPM’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate usually uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a baseline “fair value” reference line.
In the following chart, the fair-value reference line is orange, and the black line is JPM’s actual price. I’ve circled JPM’s current P/E ratio of 11.5 as well as the ratio of 15.0 that was used to plot the orange reference line.
Since the black price line is beneath the reference line, that suggests that JPM is undervalued.
To calculate the degree of undervaluation, we make a ratio out of the P/Es. So for the valuation ratio, we have 11.5 / 15 = 0.77. In other words, JPM is 23% undervalued as estimated by this first method.
We calculate the stock’s fair price by dividing the actual price by the valuation ratio. We get $109 / 0.77 = $142 for a fair price.
Note that I round dollar amounts to the nearest dollar to avoid creating a false sense of precision. Valuation ultimately depends upon future events, so it cannot be precisely known in real time. Valuations are assessments, not physical measurements.
Step 2: FASTGraphs Normalized. The second valuation step is to compare the stock’s current P/E to its own long-term average P/E.
JPM’s 5-year average P/E is 12.6 (circled). As before, the stock appears to be undervalued.
Using the same calculation methods as above, we get the following results for JPM’s valuation.
- Valuation ratio: 11.5 / 12.6 = 0.91, or 9% undervalued
- Fair price: $109 / 0.91 = $120
I consider any valuation within +/- 10% of fair value to be fairly valued, again in recognition of the fact that valuations are assessments rather than physical measures.
Step 3: Morningstar Star Rating. Morningstar takes a completely different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
My experience with Morningstar is that they have an admirably comprehensive and detailed approach. They make logical, conservative projections of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money.
The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar gives JPM 3 out of 5 stars, meaning that they consider the stock to be fairly valued.
Morningstar calculates JPM’s fair price at $112, meaning that it’s selling at a slight 2% discount to their fair value assessment.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield. This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa).
This chart shows JPM’s current yield (green dot) compared to its 5-year average (horizontal line).
[Source: Simply Safe Dividends]
JPM’s 5-year average yield is 2.65%, while its current yield is 2.92%. When the current yield is higher than the historical average, that suggests undervaluation.
JPM’s current yield is 11% above its 5-year average. Flipping it around to get a valuation ratio, we get 2.65% / 2.92% = 0.9. Once again, that’s within my 10% band of fair valuation.
Using the valuation ratio of 0.9, JPM’s fair price computes to $109 / 0.9 = $121.
Here’s a summary of the four methods:
The average fair price of all 4 valuation methods is $124. I estimate that JPM is 12% undervalued.
For comparison, CFRA computes a current fair value of $122.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for two reasons:
- They present fewer occasions to react emotionally to rapid price changes like sudden price drops that can induce a sense of fear.
- There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
JPM’s 5-year beta is 1.2, which means its volatility has been 20% higher than the market’s, which is defined as the S&P 500.
This is a negative factor.
In their most recent report on JPM, CFRA shows the recommendations of 29 analysts who cover the company. Their average recommendation is 3.6 on a scale of 5, which is midway between 3 (hold) and 4 (buy). This is a slightly positive factor.
What’s the Bottom Line on JP Morgan Chase?
Here are JPM’s positives:
- Strong dividend record: Decent yield (2.9%) combined with a strong double-digit increase record over the past 5 years. 2019’s increase will come in October.
- “Safe” dividend safety grade of 79/100 from Simply Safe Dividends, suggesting that the dividend is unlikely to be cut.
- JPM has come out of the financial crisis as arguably the strongest bank in the world. It holds leading market positions in a variety of banking sectors and activities.
- Solid, future-focused business model, focused on both growth and efficiency.
- Wide moat rating from Morningstar, high Safety rating from Value Line, and solid A- credit rating from S&P.
- Strong financials with a “fortress balance sheet.” Diverse revenue streams.
- Stock is 12% undervalued.
And here are JPM’s negatives:
- Being in the banking business, JPM is subject to the vagaries of international banking upheavals.
- As a systemically important player in the USA’s and world’s financial structure, JPM is subject to constant and intense regulatory scrutiny.
- JPM’s stock price has been more volatile than average.
In my opinion, JPM seems like a very attractive dividend growth prospect. Writing this report has got me considering JPM as a possible addition to my Dividend Growth Portfolio, which currently contains no financial-sector companies at all.
Here are recent articles on Daily Trade Alert about JPM:
- Buffett’s Latest Trades – 5 Buys, 5 Sells (May, Jason Fieber – Buffett made a large purchase of JPM))
- JP Morgan Chase: A Quality Bank and Dividend Growth Stock (April, by Brian Bollinger)
- Why Warren Buffett Thinks JP Morgan’s Stock Could Soar (March, by Billy Duberstein)
- This Blue-Chip Stock Yields 3% and Looks Like an Attractive Buy-and-Hold Investment (March, by Tom Taulli)
Finally, remember that this is not a recommendation to buy, hold, or sell JP Morgan Chase. Always do your own due diligence. Think not only about the company’s quality, dividend outlook, and business prospects, but also about how and whether it fits your personal financial goals.
— Dave Van Knapp
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