The 3 Keys to Wells Fargo's Returns

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Despite constant attempts by analysts and the media to complicate the basics of investing, there are really only three ways a stock can create value for its shareholders:                                   

  1. Dividends.
  2. Earnings growth.
  3. Changes in valuation multiples.

In this series, we drill down on one company's returns to see how each of those three has played a role over the past decade. Step on up, Wells Fargo (NYS: WFC) .

Wells Fargo shares returned 62% over the past decade. How'd they get there?

Dividends accounted for most of it. Without dividends, shares returned 23% over the past 10 years.

Earnings growth was remarkably strong during the period. Wells Fargo's earnings per share grew at an average annual rate of 11.8% per year over the past 10 years. That's a stellar performance given the financial crisis, and highlights management's knack for steering clear of most of the rotten lending practices and disastrous acquisitions that have plagued rivals Citigroup (NYS: C) and Bank of America (NYS: BAC) .

But if earnings growth was so strong, why were returns so weak? This chart explains it:

anImage

Source: S&P Capital IQ.

Like most banks, Wells Fargo's valuation multiple has dropped precipitously for the past five years. Even though earnings have grown, the market doesn't value those earnings as much as it did in the past -- or, more precisely it's losing faith in the bank's ability to generate future earnings. Part of this is rational: Loan demand across the country has been weak, Europe is on the brink of a sovereign debt crisis, and the housing market is still a mess. Morgan Stanley (NYS: MS) and Goldman Sachs (NYS: GS) now actually trade well under book value, a sign of how much pessimism is running through the banking sector.

But with Wells Fargo shares now trading at about book value -- a level that would have been unthinkable a few years ago -- you have to ask if the sell-off has gotten ahead of itself. As the earnings performance show, Wells is a well-run bank with a strong track record of keeping its head on straight. Barring a collapse of the financial system, shares could very well be cheap at these levels, meaning shareholders could benefit from not just earnings growth and dividends, but valuation expansion, going forward.

Why is this stuff worth paying attention to? It's important to know not only how much a stock has returned, but where those returns came from. Sometimes earnings grow, but the market isn't willing to pay as much for those earnings. Sometimes earnings fall, but the market bids shares higher anyway. Sometimes both earnings and earnings multiples stay flat, but a company generates returns through dividends. Sometimes everything works together, and returns surge. Sometimes nothing works and they crash. All tell a different story about the state of a company. Not knowing why something happened can be just as dangerous as not knowing that something happened at all.

At the time this article was published Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Bank of America, Citigroup, and Wells Fargo. 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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