by Eli Inkrot
JPMorgan Chase & Co. (NYSE:JPM) had a long and impressive dividend increase streak for quite some time.
Then the financial crisis came, and what was once a $0.38 quarterly dividend was slashed to just $0.05. For an income investor relying on the cash dividends from this security, that’s not going to be good news. And from this fact alone, it’s easy to write this security off.
However, I would like to make a few points before getting to today’s situation.
First, the dividend was effectively “forced” to be cut. This doesn’t give much solace to the retiree living off dividends, but it is nonetheless interesting to note that JPMorgan had the ability to keep making its payment but the company faced regulators.
Next, often times of distress actually tend to be quite good periods for investment.
And finally, the previous mark has now been restored and is actually higher as the quarterly dividend sits at $0.44.
So let’s keep an open mind and think a bit about the future.
Banks Becoming Utilities: Industry Overview
First I’d like to talk about the sector in general terms. A lot of people are concerned that large banking institutions are becoming more like utilities. As a result of increased regulation, including higher capital requirements, investors are expecting banks to grow at a slower rate than what we have been accustomed to seeing.
The specifics are a bit complex, but the logic is simple. Banks make money by lending out capital (among other services). They earn profits on the difference between the interest they collect (think mortgages) and the interest that they must pay out (think CD’s). In addition, banks are able to utilize leverage to increase the returns that they generate.
The higher the leverage the riskier banks become in poor economic times. So the new regulations require that banks hold more capital and decrease their leverage. Thus the returns that they are able to generate, as compared to say a decade ago, could certainly be lower moving forward.
This is a real possibility and should be thought about appropriately. However, that’s not to suggest that this fate has already been written in stone. For instance, while regulation could certainly act as a headwind, the possibility of higher interest rates in the future could be a tailwind. These items could net out, resulting in reasonable growth after all.
In short, for banking in general I’d expect two things. One, you’d generally anticipate that banks would be safer as a result of the new guidelines. Not “safe” mind you, but at the very least better capitalized and able to take on the next crisis. Second, I would expect the future growth rate of the firms to be in line with or even a bit below what it has been in the past.
Now I’d like to move on to JPMorgan specifically.
JPMorgan The Business
JPMorgan CEO Jamie Dimon’s most recent shareholder letter summarizes the business very well. The level of communication in the shareholder letter is higher than what most corporations give.
The image below shows how JPMorgan has continued to thrive over the last decade – despite the Great Recession:
Remember that increased regulation results in the possibility for slower growth; that’s the negative. The positive is that you’re also “forcing” the banks to become stronger.
Here’s a particularly telling exchange framed as a Q&A in the letter:
Question: “You say you have a “fortress balance sheet.” What does that mean? Can you handle the extreme stress that seems to happen around the world from time to time?”
Answer: “Nearly every year since the Great Recession, we have improved virtually every measure of financial strength, including many new ones. It’s important to note as a starting point that in the worst years of 2008 and 2009, JPMorgan Chase did absolutely fine – we never lost money, we continued to serve our clients, and we had the wherewithal and capability to buy and integrate Bear Stearns and Washington Mutual.”
I think that’s an important starting point.
It’s so easy to get wrapped up in the idea that we’re talking about a bank and the financial crisis happened. Or that the dividend was cut significantly and the share price was basically cut in half.
Yet during all of it, every quarter, JPMorgan was still turning out a profit. Granted the profits did fall dramatically, but it was never as if the company was in jeopardy.
One of my sayings is that:
“a business that doesn’t make money doesn’t get to call itself a business for very long.”
Well there’s a corollary to that:
“It’s hard to go bankrupt if you keep generating profits.”
It’s Hard To Go Bankrupt If You Keep Generating Profits
There was certainly a lot of fear out there, but JPMorgan as an ongoing concern remained steady. And just as importantly, if the company can still generate profits in the worst of times, it gives you an idea of what’s possible for better times.
Later on in the shareholder letter Jamie Dimon added the following information related to the Comprehensive Capital Analysis and Review (CCAR) that is performed each year:
“The capital we have to bear losses is enormous. We have an extraordinary amount of capital to sustain us in the event of losses. It is instructive to compare assumed extreme losses against how much capital we have for this purpose.”
“JPMorgan Chase alone has enough loss absorbing resources to bear all the losses, assumed by CCAR, of the 31 largest banks in the United States. Because of regulations and higher capital, large banks in the United States are far stronger. And even if any one bank might fail, in my opinion, there is virtually no chance of a domino effect. Our shareholders should understand that while large banks do significant business with each other, they do not directly extend much credit to one other. And when they trade derivatives, they mark-to-market and post collateral to each other every day.”
In my view, and clearly in the view of Jamie Dimon, JPMorgan has emerged to be a much stronger company. Now let’s think about the security specifically, keeping the above information in mind.
In the following sections I’d like to talk about five basic areas:
- Earnings growth
- The dividend
- Share repurchases
- What remains after dividends and share repurchases
In doing so I’m going to be making some assumptions. The goal is to come with a reasonable (perhaps cautious) set of assumptions and see what that could mean for today’s owner or prospective owner. It should be underscored that this is merely a baseline and not an absolute.
Past Earnings Growth
Here’s a look at JPMorgan’s business and investment growth from the end of 2005 through 2015:
I won’t work through everything, but I would like to highlight a few items.
The first thing that you might notice is that company-wide earnings growth was rather solid coming in at nearly 9% per year.
The share count increased a bit during this time (from about 3.5 billion to 3.7 billion) but this was much less than many other banks during the recession. Overall investors would have seen their underlying earnings claim increase by about 7.4% during the last decade.
That’s notable in my book. Here you had the worst financial crisis we’ve ever seen, and yet the bank was still able to provide very solid results over the long-term. Incidentally, if this sort of exercise does not pave the way for thinking in years instead of days, I’m not sure what will.
The valuation that investors were willing to pay for shares declined a bit during the period – from 13 down to 11 – so the share price growth trailed the annual EPS growth a bit. The dividend still grew, but not quite as fast as the earnings. Thus you have a payout ratio that actually decreased during the time.
Put together an investor would have seen total gains on the magnitude of 7% per year. As a point of reference, that’s the sort of thing that would turn a $10,000 starting investment into about $19,500 ten years later.
That’s what happened with the security in the past, which can be a useful baseline moving forward.
Future Earnings Growth
Naturally this part is unknown, but we do have some information. Analyst estimates for future intermediate-term growth have been in the 6% to 7% range. Let’s use 6% as our baseline.
Should JPMorgan be able to increase its earnings-per-share by 6% annually, after a decade you would anticipate the company to be earning $10.75 or so. We’ll leave that part for now and move on to the next step.
What’s interesting about JPMorgan is that the payout ratio is lower, but so is the valuation. So you have a dividend yield that is basically in line with what it had been pre-crisis.
At present (including Q1 2016 results) the company is earning $5.90 per share and paying out $0.44 per quarter, or $1.76 on an annual basis. This represents a payout ratio of about 30%. At the very least you would anticipate future dividend growth to be in line with earnings-per-share growth. Yet this could be even greater.
If the company were able to increase its payout ratio to say 35% – not unreasonable considering the past mark and what other banks have been doing – this would imply a future dividend payment of about $3.75 after 10 years.
The dividend growth rate would be nearly 8% without paying out much more than a third of overall earnings. In total an investor might anticipate collecting $27 or so in per share dividend payments during the next decade. Much like the EPS number, we’ll leave it there for the moment and work toward the next step.
JPMorgan has the goal of paying out 55% to 75% of its profits in the form of dividends and share repurchases. If the company is paying out 30% to 35% in dividends, that leaves 25% to ~40% more to go toward share repurchases. Effectively, the company may use equal parts dividends and share buybacks for capital returned to shareholders in the coming years.
This can have an important impact. It means that perhaps $6 billion (or more) will be used for buying out partners on your behalf each year. Furthermore, given the lower comparative valuation, this also means that the share repurchase program is apt to be more effective today than it might have been a decade ago.
We could quantify this share repurchase impact with scenario analysis, but let’s keep it simple. What this means is that the business doesn’t have to grow by 6% in order for a shareholder’s underlying claim to grow by this amount.
The business could grow overall earnings by say 4% or 5%, and still generate 6% annual EPS growth. A share repurchase program, especially when used in large amounts and at lower share prices, can fuel some per share growth.
If the company is targeting a 55% to 75% net payout ratio, this means that there are additional resources available to be deployed productively. Granted some of this may be “tied up” in the way of capital expenses or required obligations, but it remains that additional profits can be used to create more growth and fortify the balance sheet.
The company could use these “leftover funds” for bolt-on acquisitions, continued location growth, or to increase financial strength.
The final aspect is thinking about the valuation. Above I demonstrated that earnings-per-share of $10.75 after ten years could be within the realm of possibility. (And remember, this is merely a baseline and ought to be adjusted according to your own expectations.) This is fueled by “organic” growth, share repurchases and allocating “leftover” funds.
Over the past decade shares of JPMorgan have traded with an average multiple of around 11 or 12. Using 11 as a baseline seems like a reasonable estimation. Granted you could argue that a lower multiple is possible, but then again this would further fuel the effectiveness of the share repurchase program and potentially increase the overall growth rate.
Putting It All Together
So let’s put everything we just talked about together. Should shares of JPMorgan earn $10.75 in the future and trade at 11 times earnings this would indicate a future share price of about $118. If the dividend grew at almost 8% per year, you would also collect $27 or so in per share dividend payments. Your total expected value would be around $145. In other words, based on today’s share price, that represents an annualized return of nearly 10%. As a point of reference, that’s the sort of thing that could turn a $10,000 starting investment into $25,000 after a decade.
Here’s what that looks like in table form:
The middle column shows the same historical information as presented above, for reference purposes. The right-hand column details the assumptions we just ran through, keeping in mind that is this is only a baseline.
I don’t think that those assumptions are particularly ambitious. You could argue that the 6% earnings growth rate is a bit lofty, but that is slower than the company achieved in the past and could be further boosted by the potential for share repurchases and outside growth.
Beyond that, you’re assuming that the dividend payout ratio doesn’t go above 35% and that shares continue to trade hands below 12 times earnings. It’s not like you need spectacular assumptions to make a compelling case.
Naturally if things turn out better or worse than expected your anticipated returns would follow suit. Although very specific numbers were used, the idea is not to predict things perfectly. Instead it’s about coming up with a baseline and recognizing that a wide range of possibilities can occur.
It’s certainly possible that slower growth may come about in the way of more regulation. Yet I think you have a variety of lasting positives ranging from the potential of higher interest rate tailwinds and an effective share repurchase program to a solid starting dividend yield (that’s expected to grow faster than earnings due to a low payout ratio) and a fair valuation.
Not only that, but you have all of these things coming from what is becoming a better and perhaps safer institution.
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