This Brokerage Seems a Bit Pricey

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Charles Schwab (NYSE: SCHW) is one of the largest U.S. brokerage firms, with almost 9 million client accounts and assets of almost $2 trillion. Schwab offers retail brokerage services, services to investment advisors, as well as retirement plan services and more. While new account growth is weaker than it has been in the past, client trading activity is on the rise (as happens during most bull markets), making this sector a potential beneficiary if the U.S. economic recovery continues. With a good growth rate, but high valuation, is Schwab a buy, or would investors be better off looking at a competing brokerage, such as TD Ameritrade (NYSE: AMTD) or E*Trade (NASDAQ: ETFC)?

How does Schwab make its money?

Schwab separates its business into three distinct segments. The Investor Services segment makes up 39% of the company’s revenue and includes the company’s retail brokerage and banking businesses, and offers its clients the opportunity to buy and sell securities in their personal accounts. The brokerage also offers clients a range of investment planning tools and professional advice from Schwab’s portfolio consultants. 

Schwab’s Advisor Services segment accounts for 40% of the company’s revenue and offers investment advisors a platform to conduct their business, including managing their clients’ accounts. Finally, the Other Institutional Services segment that makes up the remaining 21% of the company’s revenue includes a variety of services, such as retirement plans, services to investment plan administrators, mutual fund clearing services, and more.

Growth and valuation: too expensive?

With profits highly dependent on interest income, Schwab is likely to have slow revenue growth until the Fed raises rates. While this is unlikely to happen anytime in the near future, it does provide a very interesting growth opportunity once it does happen, most likely in a year or two. Additionally, there has been a recent trend starting of investors moving money into equities from cash and bonds, which should provide Schwab (and its competitors) with increased income from trading commissions.

Schwab is expected to post earnings of $0.73 per share for the current fiscal year, rising to $0.86 and $1.03 in 2014 and 2015. This means that shares trade for 28 times this year’s earnings, which sounds reasonable for a company with 18% annual earnings growth projected over the next two years. Before we go jumping in, let’s take a quick look at two other major retail brokerages that Schwab competes with.

Alternatives: TD Ameritrade and E*Trade

TD Ameritrade is a leading Internet-based discount brokerage and caters to active individual investors. The company has about 6 million client accounts and offers some of the most highly-regarded trading tools in the industry, such as trading platform thinkorswim, which they acquired in 2009. TD Ameritrade seems to be a bit expensive right now at 21.6 times this year’s earnings, which are expected to rise by 10.8% and 14.6% during the next two years.  

E*Trade is another story altogether. E*Trade was hit very hard by the housing market collapse due to its exposure to mortgage loans, an area that its competitors have not ventured into. As a result, the company has not been profitable in years, and the last time an annual profit was reported was in 2006. E*Trade does look like it is slowly but surely getting its act together, and the consensus calls for the company to post a profit this year of $0.48 per share. As E*Trade’s balance sheet improves, so should its profits, but it is by no means a sure bet for any long-term investment.

Buy, Sell, or Hold?

In the cases of Schwab and TD Ameritrade, the stocks seem reasonably valued, but still are a bit expensive when factoring in the risk. After all, these businesses are highly dependent on interest income, and I believe that the anticipation of rate hikes coming sooner rather than later are somewhat priced into these companies and factored into their earnings growth projections. The economy improving to the point of rate increases is far from a done deal, so I would need to see a pullback in these stocks before I would be a buyer of either. E*Trade, on the other hand, seems fairly valued and may actually have the best risk/reward ratio of the three, but it is still far too risky for anything more than a speculative investment at this point.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends TD Ameritrade. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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