Why E*Trade Had a Great Year and Is About to Have Another

With the company's stock price more than double where it was at the start of 2013, it has certainly been a very good year for E*Trade Financial shareholders. When a move like this occurs, it should provoke a few questions.

First, why did shares climb so much? Is the move justified and sustainable? And finally, where do we go from here? Let's take a look at the progress E*Trade made this year and where it may be headed in 2014.

Major developments
After posting losses (some very large) in five out of the last six fiscal years, it looks like E*Trade will return to profitability for 2013. While the expected earnings of $0.68 per share for the year aren't quite where investors would like to be, it's definitely an important step in the right direction.

The company's financial health has improved thanks to a combination of good management and positive economic conditions. For example, E*Trade recently reported $46 million of provision for its legacy loan portfolio (a.k.a., bad mortgages on the company's books). This is down by more than 140% from the third quarter of last year and is at the lowest level since before the financial crisis occurred.

Also, the improving real estate market has caused the loans in the portfolio to be worth more, as many loans that were previously underwater now have positive equity. The company's one-to-four family home loans have a loan-to-value ratio of 94% currently, meaning that the average "legacy loan" now has 6% positive equity.

The company has also come a long way in improving its brokerage business, adding about 100,000 new accounts over the past year. The company will lose considerable revenue from the recently announced sale of its market-making business, which generated $93 million for E*Trade in 2012 but, in my opinion, was a good sale amid today's low-volatility market environment.

Valuation
The consensus is unanimous among the nine analysts who cover E*Trade in that they agree the company will sustain and grow its profits going forward. Earnings of $0.80 and $1.06 per share are expected for the next two fiscal years, and the estimate range is pretty tight, indicating most analysts are fairly confident about E*Trade's future. This translates to an average annual earnings growth rate of 25% for the next couple of years, which more than justifies the seemingly high valuation multiple of 29 times this year's earnings.

For comparison's sake, let's take a look at how the market values TD Ameritrade and Charles Schwab . TD Ameritrade, which never really got itself into much trouble during the crisis, has remained profitable and is expected to grow its earnings by around 14.5% annually going forward. It trades for 25 times 2013's earnings. Schwab is projected to grow its earnings faster at 21% annually, but trades for a price-to-earnings multiple of 34, much higher than either of the others.

Granted, while both of these look much more expensive than E*Trade, the risk level of both of the other companies could be much lower. Specifically, they don't have E*Trade's exposure to potentially bad mortgage assets, which leave the company vulnerable to an entirely different set of variables than the other two companies.

For instance, it is true that E*Trade's loan losses have improved, but that has a lot to do with the improved U.S. housing market. What if real estate were to crash? E*Trade could be looking at huge loan losses, while the other brokerages would be relatively unscathed.

Worth buying at these prices?
I believe E*Trade's growth potential definitely outweighs the continuing risks at the current share-price level. Experts predict that U.S. home prices will rise an additional 3%-5% during 2014, which makes a tremendous difference in the value of E*Trade's loan portfolio. That would mean that the typical E*Trade home loan, which currently has a loan-to-value of 94%, would improve to almost 91% on the low end. This would make a tremendous difference considering E*Trade's loan portfolio is worth $9 billion currently.

The bottom line is that if the U.S. economy continues to improve at least as much as the experts are projecting, E*Trade could greatly outperform the market in 2014 and is still worth a look, even at the higher share price.

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The article Why E*Trade Had a Great Year and Is About to Have Another originally appeared on Fool.com.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends TD Ameritrade. The Motley Fool owns shares of 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.

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