Charles Schwab: A Timeless Franchise, But Is It Too Expensive?

Source: Company

Charles Schwab Corporation offers investors cyclically charged earnings thanks to its highly stock market-dependent business model of providing brokerage and advisory services to clients.

Though the brokerage firm benefits from rising equity indices, higher trading and investment activity and a strong brokerage franchise that helps in attracting trillions of client dollars, Charles Schwab seems to be priced to perfection with a P/B ratio of 3.60.

Cyclical business model
Charles Schwab operates a fairly straight forward enterprise model: It provides brokerage and investment management services to institutional and retail clients and benefits from increased trading propensity.

Like any other financial services business, Charles Schwab's earnings profile is largely dependent on the overall state of the economy, or more precisely, on investors' desire to invest their cash and trade securities on the capital market.


Being even more simplistic: Charles Schwab does well when the stock market indices reach new highs and investors are excited to buy and sell stocks, bonds and other financial instruments.

Source: Charles Schwab Annual Report 2013

As many investors may remember, investor pessimism peaked in March 2009 as stocks marked their lows and uncertainty couldn't be any higher.

Not surprisingly, investor negativity and the flight to safety didn't help financial services businesses like Charles Schwab whose main job is to attract funds for its brokerage and asset management business.

As investors anticipated a severe recession in 2009 and shied away from the stock market, Charles Schwab's asset management and administration fees declined a whopping 20% in 2009 and another 3% in 2010.

Though revenues bounced back quickly, the volatility in revenues is a clear reminder of the underlying cyclicality of Charles Schwab's business model.

Strong brokerage franchise
Charles Schwab has earned the trust of its clients as witnessed by an increasing flow of funds into its business. Total client assets stood at $2.25 trillion at the end of 2013 which compares against client assets of $1.42 trillion at the end of 2009.

Source: Charles Schwab Interim Business Update April 2014

Net new asset inflows continued in the first quarter of 2014 when total client assets reached a record high of $2.31 trillion according to Charles Schwab's first quarter earnings release.

The brokerage firm has been quite successful in pulling in additional dollars from clients. In the first quarter of 2014 alone, Charles Schwab collected another $34.2 billion.

In terms of client assets, Charles Schwab is also doing well on a relative basis. With $2.31 trillion in total client assets, Charles Schwab is the second largest brokerage business after Bank of America Merrill Lynch which pulled in a total of $2.40 trillion.

The third largest player in the field in terms of client assets is Morgan Stanley's wealth management practice with $1.94 trillion as of the end of the first quarter.

Charles Schwab's assets under an advisory relationship,which are pretty much managed assets, increased from $686 billion in 2009 to $1.10 trillion at the end of 2013.

And new assets kept flowing into Charles Schwab's asset management business in 2014 as well: At the end of the first quarter, the financial services company reported total assets under an advisory relationship of $1.13 trillion. 

Financial performance
Charles Schwab has come a long way from being just a discount brokerage business and the company has evolved into an integrated financial services company which is riding high on its asset management business.

For the first quarter in 2014, Charles Schwab reported strong revenue growth in its most important business segment 'asset management and admin fees' which posted 11% y-o-y revenue growth.

With improving optimism in the equity markets, Charles Schwab will probably see further revenue momentum in its dominant service line in the short-term. However, given the good run of the equity indices over the last five years and the advanced stage of the bull market, Charles Schwab's revenues and earnings will take a hit as soon as equity indices are tanking.

Relative valuation
Though I like Charles Schwab's business model and its strong franchise, the brokerage company clearly trades at a premium valuation.

Similar to TD Ameritrade, Charles Schwab trades at a whopping premium of more than 250% to book value. E*trade Financial, for instance, trades at only 1.25 times book value.

The Foolish Bottom Line
I have to say, I do like Charles Schwab's evolution as an asset management business and its strategic move away from the discount brokerage model. However, at nearly 3.6x book value investors price Charles Schwab for perfection.

The bull market has already been rolling along for the better part of five years and equity indices will correct at some point, which should immediately affect Charles Schwab's business and its valuation.

At a 250% premium to book value, I see limited valuation upside potential given how advanced the bull market already is.

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The article Charles Schwab: A Timeless Franchise, But Is It Too Expensive? originally appeared on Fool.com.

Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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