We closed this position on March 2, 2011. A copy of the associated Position Update report is here.
- Misleading earnings = accounting profits are positive and rising while true, economic profits are negative and falling
- High Valuation = very high expectations embedded in the current valuation.
- Misleading Earnings: COF reported a $399mm increase in GAAP earnings while our model shows economic earnings declined by $1,783mm. The main drivers of the difference between Economic versus Accounting earnings are COF’s (a) nearly $400mm draw-down from its Loan Loss Reserves, (b) $1,353mm of off-balance sheet debt and (c) $1,544mm in asset write-offs.
- The company’s ROIC is in the Bottom Quintile of all the companies we cover.
- Stock price of $40.69 implies COF must grow its NOPAT at 15% compounded annually for 15 years. A 15-year Growth Appreciation Period with 15% compounding growth rate is quite a high standard to beat, as per my post on How To Make Money Picking Stocks.
Overall, the Risk/Reward of investing in Capital One’s stock looks Very Dangerous to me. There is lots of downside risk given the Misleading Earnings and there is little upside reward given the already-rich expectations embedded in the stock price.
See Appendix 4 to learn how COF NOPAT plummeted even though Net Income rose in its last fiscal year based on COF’s drawing cash out of its loan loss reserve. See Appendix 5 for details on COF’s Invested Capital. Appendix 7 (in the Return on Invested Capital section) shows how the falling NOPAT Margin and flat Invested Capital Turns result in a decrease in ROIC (to 1.6% from 6.2%) and Economic Profit, which fell by $1.8bn while Net Income rose by only $399mm.