Valuing US Bancorp

I first spotted US Bancorp (USB) when reviewing Berkshire Hathaway’s stock holdings back in February. This past week I read about US Bancorp again when a member of Value Investing News posted a link to “The Complete User’s Guide to Warren Buffett’s Portfolio” by James Altucher. I have been meaning to analyze US Bancorp for the past month, but my lack of skills in valuing banks has kept me from spending the time that I would need to analyze this company. Jame’s article convinced me it was time to upgrade my skills and tackle valuing US Bancorp.

James Altucher made some great points in his article for why Warren Buffett has added to his position in US Bancorp and why it might still be a good buy now.  US Bancorp has been outperforming other banks with a 23 percent return on equity.  The average for the banking industry as a whole is only 10 percent. Even more impressive is the fact that US Bancorp’s return on equity has been increasing even while the yield curve has inverted. Many banks struggle to be profitable when short term interest rates climb above long term interest rates because it makes it difficult for them to profit from the spread between the money they lend out and the interest they pay depositors.

James’s thinks Wall Street is throwing the baby out with the bath water with US Bancorp. The collapse of stock prices in the subprime mortgage sector has also dragged down stock prices for almost all banks. There is widespread concern about credit quality.  However as James points out, the credit quality of US Bancorp’s loans has actually gone up over the past quarter.

Warren Buffett is an expert in investing in regional banks. Given that USB is almost 5% off its recent lows and its price is close to what Warren Buffett recently purchased it for, James argues that the stock is a strong buy here. The argument is very compelling, so I decided to try my hand at valuing this company.

Since I’m not familiar with valuing bank stocks, I decided to visit the website of an expert on stock valuation, Aswath Damodaran.  On his site, I found a dividend discount model spreadsheet designed specifically to value financial service called eqexret.xls. The spreadsheet uses the payout ratio for the high growth period and the expected growth rate in earnings per share to estimate the expected dividends in the high growth period.  The expected growth rate in earnings is calculated by simply taking the retention ratio and multiplying it by the return on equity.  I understand the basics of how this model works, but I’m not familiar enough to know its weaknesses.

I used the following inputs in the dividend discount model:

  • Net Income = $4,703.00
  • Book Value of Common Equity = $20,197.00 in 2006 and $20,086.00 in 2005
  • Current Earnings per share = $2.64
  • Current Dividends per share = $1.39
  • Number of shares outstanding = 1,778
  • Beta of the stock = 1.00
    (It was actually 0.75 on Yahoo but I prefer to use a risk neutral beta.)
  • Riskfree rate= 4.65%
  • Risk Premium= 5.00%
  • Length of high growth period = 10 years
    (Because I feel this is a wide moat business.)
  • Growth rate in stable growth period = 5.0% based on nominal GDP growth

After making these inputs the spreadsheet output the following:

  • Return on Equity = 23.41%
  • Retention Ratio = 47.35%
  • Expected growth rate = 11.09%
  • Cost of equity = 9.65%

Since earnings have been stable at US Bancorp, I did not normalize earnings.  I also maintained all the same inputs for the stable growth period, except for the growth rate.  The bottom line is that I found each share of USB to worth $62.69. Shares of USB are currently trading for $34.90, so the margin of safety is 44%.

I definitely encourage you to review my inputs and assumptions. You can review my whole USB dividend discount model spreadsheet online using Google Spreadsheets. I’m sure many of you have a different take on these inputs and some of you might even challenge the model I used. Do you know of a better way to value banks? Share your thoughts below. I look forward to the discussion.

Full Disclosure: I do not currently own shares in any of the stocks discussed in this article.

9 thoughts on “Valuing US Bancorp

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  • March 30, 2007 at 11:21 pm

    His website is one of the best resources I have seen – ever. Thank thank for sharing.

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  • April 1, 2007 at 1:02 am

    I do not get UBS or bank of granville. Yes they are well run banks, but they have slower growing and have higher multiples than the average bank. I swear buffet pays a premium sometimes for people he knows and companies where he has direct contact or insight.

    5 year sales are a steady flat line growth rate of 3.8% to 4.9%.
    5 year Earnings are growing at 8.9% to 10.5%.

    ROE average is steady at 21.0

    Based on UBS earning $3.92 in 2012 and using a PE range of 8 to 13, the company will sell in for between 31 to 51 in 2012.

    Average return including dividends of about 7.2% to 11.1%

  • April 1, 2007 at 9:22 am

    The way this market is going, maybe, just maybe…..
    “A bird in the hand is worth two in the bush”

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  • April 2, 2007 at 12:16 pm

    I have several issues with this approach.
    1.) We don’t know the future… future period of high growth, future dividend payouts etc…
    2.) The risk free rate should be the T-Bill (3m) not 10-year yield. Difference of 50 bps
    3.) We can’t expect the current earnings to continue at record profit margins.

    The Graham & Dodd approach is to use the 10-ear average earnings adjusted by inflation, i.e. bump prior years’ EPS up by the amount of the loss of purchasing power. I use the CPI for this, you can use gold, money supply supply, or whatever floats your boat. This will change your pay-out ratio as well. My method, I add current dividends and the 10-year avg (inflation adjusted earnings) and divide the whole thing by a required return, which should be at least the Baa Corp bond yield of 6.39% or so.

    Using this method you’ll find that there is very little marging of safety. I don’t have this companies financials at hand, so I don’t know what you’d come up with, but my guess it would be below the current price.

    It’s funny how after years of bull markets how everything just gets “cheaper”. Remember how “expensive” everything was in late 2002, when the analyst expectations were for losses to continue forever. Now we see the mirror image.

    I’m not saying the stock won’t go up. Gerry Loeb pointed out in correctly The Battle for Investment Survival that markets can go years without reflecting “fair values”. My only point is that most “Fundamental” models of today are used to justify the belief that stocks should “go up”.

    If you truly believe that the credit deterioration is not going to effect bank earnings, then maybe this model is right for you.

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