Derek W. Smith
Capital One Financial Corp. (COF)
Initiating Coverage with a Hold Rating
Analyst Information
Derek Smith
Smith.3879@osu.edu
11/29/2004
Key Reasons for recommendation

Stock Rating
Hold
Recent Price (11.29.04) $80.00
Target Price
$87.02
52-week range
$55-$80

Stock Data*
Market cap
Shares outstanding
Beta
Dividend Yield
$19.4B
242.7M
1.56
.138%
Positives
o Valuation
 Outperforming Peers in relative valuation
 Under priced in all intrinsic models used
o Business
 Growth and Expansion Plans for Coming Year
 Take advantage of foreign exchange
 Interest Rates Remain Low
o Financials
 Strong past growth indicates growth into the
future
Risks
o Saturation in US Credit Card Market
o Possible Earnings Manipulation via Loan Loss Reserves
o Pending Lawsuit by American Express against Visa and
MasterCard
Earnings Estimates*
2004E
2005E
2006E
$6.42
$6.96
$7.50
Valuation (P/E)
2004
2005
12.5
11.5
2006
10.7
Capital One Financial Corp
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1
Derek W. Smith
TABLE OF CONTENTS
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
Company Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Macroeconomic Environment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
a. Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1. Exhibit 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
b. Impact on Capital One. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1. Exhibit 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Industry Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
a. Diversified Financials. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
b. Credit Card Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Company Outlook. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
a. Growth Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1. Grow Credit Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2. Grow Auto Finance Business . . . . . . . . . . . . . . . . . . . . . . . . . 9
i.
Exhibit 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3. Geographic and Product Expansion . . . . . . . . . . . . . . . . . . . . 10
i.
Exhibit 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
b. Risks/Concerns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1. Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
i.
Exhibit 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2. Income Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3. Competition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Financial Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
a. Income Statement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1. Exhibit 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2. Exhibit 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
b. Balance Sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1. Exhibit 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2. Exhibit 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
c. Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1. Exhibit 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
a. Relative Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1. Exhibit 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
b. Advanced Dividend Discount Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1. Exhibit 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
c. Capital Asset Pricing Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
d. P/E Multiple Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
e. Estimated Target Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Recommendation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Models
a. Model 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
b. Model 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
c. Model 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Capital One Financial Corp
11/29/2004
2
Derek W. Smith
I. COMPANY OVERVIEW
Capital One Financial Corporation is one of the six largest issuers of credit cards in the
United States. They hold nearly 50 million consumer accounts and over $71 billion in consumer
debt. The company operates through three main subsidiaries. These include Capital One Bank,
which offers credit card products; Capital One, F.S.B., which offers consumer loan (including
credit cards) and deposit products; and Capital One Auto Finance, which provides auto loans.
The company’s strategy revolves around utilizing a proprietary Information Based
Strategy (IBS) which involves large quantities of consumer information compiled into a database
that allows the company to tailor its products and offers to each individual customer. This
allows the firm to service a wide variety of consumers with a broad array of cards ranging from a
$200-limit secured card with an annual fee (for those with poor credit) to a 9.9% annual interest
rate and no fee (for "super prime" customers with little credit risk). Furthermore, Capital One’s
vast knowledge of each consumer they deal with allows them to offer products such as home
mortgages, car insurance, and shopping catalogs to customers that call in to check balances or
make payments to their accounts which further increases revenue. 1
II. MACROECONOMIC ENVIRONMENT
A. Overview
Real GDP for the third quarter of 2004 rose at an annual rate of 3.7%. While this was
below consensus estimate of 4.3%, it is still a positive sign of a growing economy. Furthermore,
economy-wide demand rose by a 4.6% rate, but output growth was pulled down by a higher trade
deficit and slower inventory growth domestically. It also seems that inflation is under control.
After rising above 3% in the first half of 2004, it has dropped below 2% for the third quarter.
The Warburg Inflation index is also currently at -0.3% and indicates that there is little worry of
inflation spikes in the near future (See Exhibit 1). Additionally, the federal funds rate is
1
Hoovers Online. Available via Ohio State University Library
Capital One Financial Corp
11/29/2004
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Derek W. Smith
currently at 2% after an increase of 25 basis points for the fourth consecutive time on November
10, 2004.2
Much of the economy’s growth can be attributed to government spending and consumers.
The governments spending in the defense sector rose at an annual rate of 9.3% for the quarter.
This spending is likely to continue as a result of the aftermath of the Iraqi War. Additionally,
consumer savings has dropped to the record low level of 0.4% indicating high consumer demand.
However, while spending is on the rise by an annualized 4.6%, income is lagging behind at only
a 1.4% real increase in after-tax income. Thus, this increase in spending is being caused by
increased personal debt and does not seem to be sustainable without increases in production and
real income. This increase in production is likely to occur in early 2005 as a result of
productivity that has yet to be realized after the technology bubble. Exhibit 1 shows the
increasing production in the economy and a below average utilization rate showing room for
increased productivity. In the late 1990’s companies spent a large amount of money on
upgrading their technologies, and with demand being as strong as it is currently these companies
are likely to increase output by utilizing this technology. This increase in production in 2005
will increase revenue, and increase hiring and consumer income as a result causing further
growth and expansion throughout the duration of the year.2
2
Economic Policy Institute. Available online:
www.epinet.org/content.cfm/webfeatures_econindicators_gdppict_10292004
Capital One Financial Corp
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Derek W. Smith
Exhibit 1
StockVal®
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
120
2006
HI
119.80
LO
85.61
ME 111.42
CU 119.80
GR
3.4%
110
100
90
11-30-1994
10-31-2004
80
MANUFACTURING PRODUCTION
88
HI
LO
ME
CU
84
80
76
84.42
72.00
81.11
75.90
11-30-1994
10-31-2004
72
MANUFACTURING UTILIZATION RATE %
7
HI
LO
ME
CU
6
5
4
6.30
3.80
5.30
5.50
11-30-1994
10-31-2004
3
UNEMPLOYMENT RATE,SA %
120
HI
LO
ME
CU
GR
115
110
118.00
102.40
113.70
113.80
-0.3%
105
11-30-1994
10-31-2004
100
UBS WARBURG LEADING INFLATION INDEX
B. Impact on Capital One
With consumer spending at such a high level, Capital One has been able to take
advantage as consumers racked up debt in order to satisfy their demand. The firm’s profits
jumped 78% from a year earlier, to $490.2 million and managed loans rose 12.19% year over
year to $75.5 billion.3 However, this does seem to be sustainable growth for the company. As
these debt obligations grow among consumers they will be forced to pay down this debt instead
of spending more on consumer products and services. Additionally, this poses more risk to a
credit issuer like Capital One as consumers incur a larger amount of floating debt in a rising
interest rate environment. Many debts could grow out of control for borrowers and become bad
debt expense to the issuers (i.e. Capital One) causing these recent gains to quickly become
losses.
Rising interest rates may also prove to be a difficulty for the firm’s other lending
practices such as mortgages and auto financing. As rates rise, consumers may be less likely to
Kuykendall, Lavonne. American Banker. “Card Quality Better, Growth a Struggle”. 10/22/2004, Vol. 169 Issue
204, Page 1.
3
Capital One Financial Corp
11/29/2004
5
Derek W. Smith
borrow to finance purchases and instead defer the purchase to a time when rates may be more
favorable. However, this does not seem to be an immediate concern as rates are still near all
time lows. Furthermore, if the Fed continues its recent actions of raising rates, borrowing will not
be getting any cheaper in the near future which will cause fewer consumers to delay purchasing
due to financing conditions. In addition, as rates slowly increase, the spreads associated with
Capital One’s lending practices will also increase. This could help to ease the revenue declines
that will be experienced from the decrease in the volume of loans that the company has produced
over the last few years. Exhibit 2 shows how interest income for Capital One has increased over
the last two years because of the volume of loans created. The decreasing yield on these loans
has cut into this income. Over the next year, volume will be slowing and yield income will be
increasing in response to interest rate changes.
Exhibit 2
2003 vs. 2002
2002 vs. 2001
Change due to(1)
(Dollars in thousands)
Interest Income:
Consumer loans
Domestic
International
Increase
(Decrease)(2)
$
Total
Volume
Yield/
Rate
Change due to(1)
Increase
(Decrease)(2)
Volume
Yield/
Rate
142,602 $ 527,384 $ (348,003) $
(2,768)
(4,294)
3,123
1,093,666 $ 1,165,559 $ (108,672)
(30,724)
21,406
(53,727)
139,834
1,062,942
516,636
(338,426)
1,168,600
(144,034)
III. INDUSTRY OVERVIEW
Capital One operates in the Diversified Financials Industry within the Financials Sector
of the S&P 500 Index. This industry consists of special purpose lending firms and financial
Capital One Financial Corp
11/29/2004
6
Derek W. Smith
services firms (Mutual Funds, Brokerage Houses, etc.). Capital One operates as a credit services
firm within this broad industry.
A. Diversified Financials
The Diversified Financial Industry as a whole is a very mature market. Consumers have
been utilizing these types of firms for borrowing and investing for decades. However, over the
last decade, lending has experienced growth do to low interest rates and the growth of AssetBacked Securities (ABS). These conditions have allowed companies in this business to move
into more of a growth phase. ABS’s have allowed companies to sell loans to market investors
and realize gains immediately as opposed to being forced to wait for the duration of the loan.
Furthermore, they have allowed firms to spread geographic and credit risk. As a result,
companies can use the cash they receive from the sale of these loans to further grow their
business. However, while these ABS’s are positive from a cash flow stand point, they can put
companies at higher risk. These firms that sell their loans via an ABS agreement still hold
almost all of the risk of default on these loans. If a company’s loans default and investors in the
market lose money, they may lose faith in the specific company’s ABS in the future. Therefore,
any default can result in stifling the company’s ability to utilize these markets down the road.4
B. Credit Card Companies
Over the last quarter, credit quality and profits have improved for most credit card
companies. However, loan growth did begin to slow in the latter part of the quarter lead by
extremely slow growth in the credit card lending sector. Many executives and analysts attribute
this slow growth to the refinancing boom as loans shift to different categories (i.e. credit card
debt refinanced with home equity) as opposed to new loans being created. Thus, companies that
are more diversified outside of the credit card market were able to retain many of these loans in
different business segments while those that were less diversified were forced to endure a
4
Hooke, Jeffrey C. Security Analysis on Wall Street. Wiley Frontiers in Finance. New York. 1998
Capital One Financial Corp
11/29/2004
7
Derek W. Smith
decreasing loan portfolio. Additionally, credit card firms operating in higher credit risk markets
were also less susceptible to refinancing because sub-prime credit holders are less likely to own
homes and therefore do not have the ability to refinance. Capital One is both diversified into
other lending practices and holds a large amount of its loan portfolio in sub-prime borrowers.
Therefore, it was able to fair better than many of its competitors over this time period. 5
IV. COMPANY OUTLOOK
A. Growth Drivers
In the 10-K for Capital One filed for year end 2003, the company associates 3 main
drivers of growth. The first driver is to grow the credit card business by focusing on clients with
lower credit risk. Next, the company identifies building and growing the auto finance
component of their operations. Finally, Capital One recognized expanding their operations
geographically (specifically in the U.K. and Canada) and diversifying their product mix as the
final component to growth. Now we will examine these three strategies.
1) Grow Credit Card Business by Focusing on Clients with Lower Risk
On the surface, this seems like a good strategy for the company overall. Less credit risk
from borrower’s can result in lower credit risk for Capital One in the eyes of their lenders and
cause the interest rate the firm pays on loans to decrease. The firm creates profit as a spread
lender, and by loaning money at a rate higher than they borrow, they can realize a gain. The
lower the rate is that capital one can borrow at, the more revenue they can generate.
However, while this may be a good business practice, it will most likely not lead to large
growth for the firm. In the United State, 70% of consumers have at least one credit card and the
average credit card holder has between 5 and 7 cards. Even the CEO of Capital One, Richard
Kuykendall, Lavonne. American Banker. “Card Quality Better, Growth a Struggle”. 10/22/2004, Vol. 169 Issue
204, Page 1.
5
Capital One Financial Corp
11/29/2004
8
Derek W. Smith
Fairbank, admits that the American credit card market is saturated and growth here will be slow
for the near future.6
2) Build and Grow Auto Finance Component of Operations
The second portion of Capital One’s growth plan stems from growing their auto finance
business. This growth will most likely come from expansion via acquisition. This is the
approach Capital One has taken in the past, and I assume this is the approach they will continue
to take. Exhibit 3 shows limited growth in auto sales at rate of only 0.9%. Additionally, with
rates increasing as is evidence by the federal funds rate in Exhibit 3, it will be more difficult to
entice car buyers to purchase an automobile with financing options (i.e. 0% financing for 36
months). Instead, home mortgages seem to be the area of the most growth potential in terms of
financing. The current growth rate estimate on new home loans is currently at 5.7%.
Exhibit 3
StockVal®
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
195
180
HI
LO
ME
CU
GR
165
150
135
120
191.00
107.90
141.80
191.00
5.7%
11-30-1994
09-30-2004
105
NEW HOME LOANS
22
HI
LO
ME
CU
GR
20
18
22.00
14.40
16.55
17.40
0.9%
16
11-30-1994
10-31-2004
14
MOTOR VEH RS:TOTAL,SAAR (MIL)
7.2
HI
LO
ME
CU
4.8
3.6
2.4
6.86
0.96
5.14
1.99
1.6
1.2
11-25-1994
11-19-2004
0.8
FEDERAL FUNDS RATE %
Kuykendall, Lavonne. American Banker. “Card Quality Better, Growth a Struggle”. 10/22/2004, Vol. 169 Issue
204, Page 1.
6
Capital One Financial Corp
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Derek W. Smith
3) Expand Operations Geographically (U.K. and Canada) and Diversify Product
Mix
Capital One’s plan to expand its operations in the U.K and Canada seem to be a viable
option for growth. Furthermore, with the acquisition of HFS Group, a loan broker in the U.K., in
early November 2004, it shows its intentions to aggressively pursue this goal. Over the past few
years, the dollar has been losing value relative to foreign currencies, specifically the Euro and the
Canadian dollar. If Capital One can continue to expand operations in these two areas (Canada
and Europe) the firm will be able to take advantage of foreign exchange rates to further increase
earnings. Exhibit 4 shows the growth patterns of value of the Euro and Canadian dollar relative
to the US dollar with growth rates of 0.5% and 0.4%, respectively. Additionally, with rising
interest rates in both of these areas, Capital One will be able to realize larger spreads on the loans
they issue in these nations.
Exhibit 4
StockVal®
1994
1995
1996
1997
1998
1999
2000
2005
2006
1.0
HI
LO
ME
CU
GR
1.26 
0.85
1.00
1.17
0.5%
0.8
01-31-1999
10-31-2004
1.4
1.2
2001
2002
2003
2004
EUROS IN US $S:MONTHLY
8
HI
LO
ME
CU
6
7.50
3.50
5.75
4.75
4
11-25-1994
11-26-2004
2
PRIME RATE:BRITISH %
0.80
HI
LO
ME
CU
GR
0.75
0.70
0.77
0.62
0.70
0.76
0.4%
0.65
11-30-1994
10-31-2004
0.60
CANADIAN $ IN US $S:MONTHLY
10
HI
LO
ME
CU
8
6
4
9.75
3.75
6.25
4.25
11-25-1994
11-26-2004
2
PRIME RATE:CANADIAN %
Capital One Financial Corp
11/29/2004
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Derek W. Smith
The only drawback to this plan of attack is the cooling of the lending market abroad. For
the most part, interest rates in other nations have been similar to that of the US and are on the
rise (see exhibit 3) and the booming lending market of the last few years is slowing. However,
there does seem to be room for growth in Capital One’s major business operation of credit card
lending considering that only 40% of the population in Europe holds a credit card versus 70% in
the US.7
B. Risks/Concerns
1) Economic Growth
One of the main risks that the firm faces is the risk of slowing economic growth and
recession. Looking at Exhibit 5, the correlation between the firm’s stock price and production
levels in the economy are largely correlated. Therefore, if economic growth does not continue
into 2005 as is expected the company is at risk.
Exhibit 5 (COF) Price 80.0
CAPITAL ONE FINANCIAL CORPORATION
1994
1995
1996
1997
1998
1999
2000
2001
80
40
20
10
2002
2003
2004
StockVal®
2005
2006
HI
LO
ME
CU
GR
80
5
40
80
31.5%
11-25-1994
11-26-2004
4
PRICE
120
HI 117.60
LO
87.15
ME 109.98
CU 117.60
GR
3.1%
110
100
90
11-30-1994
10-31-2004
80
INDUSTRIAL PRODUCTION INDEX
120
HI 119.80
LO
85.61
ME 111.42
CU 119.80
GR
3.4%
110
100
90
11-30-1994
10-31-2004
80
MANUFACTURING PRODUCTION
9000
HI
LO
ME
CU
GR
8400
7800
8953.4
6618.9
8068.6
8953.4
3.1%
7200
11-30-1994
09-30-2004
6600
PERSONAL INCOME:REAL,SAAR ($BIL)
Kuykendall, Lavonne. American Banker. “Card Quality Better, Growth a Struggle”. 10/22/2004, Vol. 169 Issue
204, Page 1.
7
Capital One Financial Corp
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Derek W. Smith
2) Income Growth
Capital One also faces risk associated with personal income growth of consumers. Over
the last quarter, consumer spending has increased quickly and income has not kept up with the
pace. This has been good for the short run for Capital One since much of this consumption was
the result of credit card lending. However, over the long run and into 2005, the company will
rely on increases in personal income to push consumption. Without this increase in income,
borrowers could find difficulty repaying debt incurred over the last quarter in addition to not
having enough disposable income to continue consumption growth in the economy. However,
with personal income growth rate estimates of 3.1% into the next year (see Exhibit 5) this should
not be a large concern.
3) Competition
Competition will also cause some risks into the coming year. On November 15, 2004,
American Express sued Visa and MasterCard over anti-competitive practices in keeping over
200,000 banks from issuing American Express credit cards.8 If this American Express wins this
lawsuit it could cause more intense competition within the already highly competitive US
market. Since, Capital One is a major issuer of Visa and MasterCard, they could see their market
share decrease and also increased expenses if Visa and MasterCard are forced to pay damages as
a result of their practices and pass costs on to issuers like Capital One.
8
“Amex Sues Visa and MasterCard”. New York Times. November 16, 2004. Section C , Page 14 , Column 6
Capital One Financial Corp
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Derek W. Smith
V. FINANCIAL ANALYSIS
A. Income Statement
Exhibit 6
Income Statement
CAPITAL ONE FINANCIAL CORPORATION (COF)
FYE Dec
StockVal ®
2003
% Chg
2002
% Chg
2001
% Chg
2000
% Chg
1999
Interest Income ($ Mil)
4367.7
4
4180.8
43
2921.1
19
2453.9
51
1623.0
Interest Expense
1582.6
8
1461.7
25
1171.0
46
801.0
48
540.9
2785.1
2
2719.1
55
1750.1
6
1652.9
53
1082.1
Provision For Loan Losses
1517.5
-29
2149.3
92
1120.5
38
812.9
91
426.5
Other Income
5415.9
-1
5466.8
22
4463.8
46
3065.1
28
2386.4
Other Expense
4856.7
6
4585.6
13
4058.0
29
3147.7
28
2465.0
1826.8
26
1451.0
40
1035.4
37
757.5
31
577.0
675.9
23
551.4
40
393.5
37
287.8
35
213.9
Net Income Reported ($ Mil)
1135.8
26
899.6
40
642.0
37
469.6
29
363.1
Net Income Adjusted
1150.9
28
899.6
40
642.0
37
469.6
29
363.1
EPS Reported
4.85
23
3.93
35
2.91
30
2.24
30
1.72
EPS Adjusted
4.92
25
3.93
35
2.91
30
2.24
30
1.72
234103
2
228744
4
220576
5
209449
-1
210683
0.11
0
0.11
0
0.11
0
0.11
0
0.11
2785.1
2
2719.1
55
1750.1
6
1652.9
53
1082.1
Net Interest Income
Pre-Tax Income
Taxes
Shares Outstanding (Thou)
Dividends Common (Per Shr)
Dividends Preferred ($ Mil)
Net Interest Income TEB
The income statement for Capital One, in Exhibit 6, shows positive growth in
earnings and earnings-per-share for the past few years. The growth of EPS is steady and
strong at a rate of approximately 30% per year on average. Furthermore, the number of
shares outstanding has grown slowly over the last 3 years, indicating that these earnings
are a result of operations and not stock repurchasing and thus the overall market value of
the firm is growing.
The first “red flag” in the income statement is that income also continually grows,
but not at as steady of a rate as EPS. This difference in smooth growth of EPS and more
varying growth of net income indicates that management may be smoothing earnings to
please the market. This is not necessarily indicative of a bad firm, but instead could just
be managements attempt to maintain shareholder value since allowing EPS to float freely
would most likely result in negative Wall Street reaction, deserving or not.
Capital One Financial Corp
11/29/2004
13
Derek W. Smith
Another indication of earnings smoothing is the “cookie-jar” tactics the firm
seems to be using with its reserves. Looking at Exhibit 7 below, Total Loans outstanding
for the firm increased by nearly 22% while the Loan Loss Reserve decreased by over 7%.
Exhibit 7
Total Loans
Loan Loss Reserve
% of Total Loans
Net Income
EPS
2003
$31,255.30
$1,595.00
5.10%
$1,135.80
$4.85
LOAN LOSS ANALYSIS
% Change
2002
% Change
21.98%
$25,623.90
27.60%
-7.27%
$1,720.00
104.76%
-23.98%
6.71%
60.47%
26.26%
$899.60
40.12%
23.41%
$3.93
35.05%
2001
$20,081.00
$840.00
4.18%
$642.00
$2.91
% Change
37.68%
59.39%
15.77%
36.71%
29.91%
In the footnotes of the annual report, management claims that this is due to a shift in their
loan portfolio to more credit worthy borrowers. Looking at Exhibit 8 from Capital One’s
2003 10-k filing gives evidence to support this claim. Total delinquency of the loan
portfolio is at is lowest point over the last 4 years which may indicate that Capital One is
in fact increasing the number of borrowers with above average credit. However, when
the firm hit a low almost equal to 2003 in 2001, loan loss reserves were not reduced and
were instead increased by 60%. This fact leads me to question the validity of the
statements that management has made regarding the credit quality of their loan portfolio.
Capital One Financial Corp
11/29/2004
14
Exhibit 8
2002(1)
2003
(Dollars in thousands)
Loans
Derek W. Smith
2001
2000
1999
% of
% of
% of
% of
% of
Total
Total
Total
Total
Total
Loans
Loans
Loans
Loans
Loans
Loans
Loans
Loans
Loans
Reported:
Loans outstanding
$ 32,850,269 100.00% $ 27,343,930 100.00% $ 20,921,014 100.00% $ 15,112,712 100.00% $ 9,913,549 100.00%
Loans delinquent:
30-59 days
755,930
2.30%
762,040
2.79%
494,871
2.37%
418,967
2.77%
236,868
2.39%
60-89 days
362,766
1.10%
373,451
1.37%
233,206
1.11%
242,770
1.61%
129,251
1.30%
90-119 days
207,353
0.63%
238,091
0.87%
144,957
0.69%
178,001
1.18%
94,550
0.95%
120-149 days
149,246
0.45%
174,651
0.64%
85,580
0.41%
136,932
0.91%
69,706
0.70%
98,164
0.31%
125,636
0.45%
53,943
0.26%
120,641
0.79%
56,257
0.58%
586,632
5.92%
150 or more days
Total
$
1,573,459
4.79% $
1,673,869
B. Balance Sheet
6.12% $
1,012,557
4.84% $
1,097,311
7.26% $
Exhibit 9
Balance Sheet
StockVal ®
CAPITAL ONE FINANCIAL CORPORATION (COF)
FYE Dec
2003
% Chg
2002
% Chg
2001
% Chg
2000
% Chg
1999
Cash ($ Millions)
Investment Securities
Federal Funds Sold
Total Loans Net
Loan Loss Reserve
Other Earning Assets
Other Assets
Total Assets
382.2
5866.6
1010.3
31255.3
1595.0
587.8
7181.5
46283.7
38
33
170
22
-7
120
12
24
277.5
4423.7
373.8
25623.9
1720.0
267.4
6416.0
37382.4
-22
42
1788
28
105
-19
50
33
355.7
3115.9
19.8
20081.0
840.0
331.8
4279.9
28184.0
377
84
-67
38
59
226
81
49
74.5
1696.8
60.6
14585.7
527.0
101.6
2370.1
18889.3
-44
-9
52
54
-10
43
42
134.1
1856.4
0.0
9571.5
342.0
112.4
1662.0
13336.4
Deposits
Short Term Borrowings
Long-Term Debt
Total Borrowings
Other Liabilities
Total Liabilities
22416.3
4071.6
10741.0
14812.6
3002.9
40231.9
29
7
32
24
-14
23
17326.0
3807.1
8123.6
11930.7
3502.6
32759.2
35
72
14
28
30
32
12839.0
2210.1
7120.7
9330.8
2690.8
24860.6
53
-23
73
34
71
47
8379.0
2870.2
4106.4
6976.5
1571.3
16926.8
121
-7
6
0
46
43
3783.8
3083.4
3877.6
6961.0
1076.0
11820.8
6051.8
6051.8
31
31
4623.2
4623.2
39
39
3323.5
3323.5
69
69
1962.5
1962.5
29
29
1515.6
1515.6
46283.7
24
37382.4
33
28184.0
49
18889.3
42
13336.4
Minority Interest
Preferred Equity
Common Equity
Total Equity
Total Liab & Equity
Capital One Financial Corp
11/29/2004
15
Derek W. Smith
The balance sheet for 2003 (see exhibit 9) shows the growth of the firm over the last few
years by looking at the change in total assets. This growth trend will most likely continue into
the future. Most of this growth is attributed to the primary business of consumer lending. This is
evidence from the Net Total Loans held by the company which constituted almost 75% of the
first assets in the past year.
C. Statement of Cash Flows
Exhibit 10
Cash Flow Analysis
CAPITAL ONE FINANCIAL CORPORATION (COF)
FYE Dec
2003 % Chg
2002 % Chg
Exhibit
10 shows the statement
StockVal ®
2001 % Chg
Net Cash From Operations
2027.9
-19
2507.0
81
1384.9
Net Cash From Investing
-8854.6
8
-9653.3
-26
-7688.7
Net Cash From Financing
7888.3
7
7357.8
9
6774.4
51
4486.2
0.0
-119
0.0
100
-12067.5
211.5
-55
470.5
Other Cash Flows
Change In Cash & Equiv
0.0
1061.5
402
-10
of
2000cash
% Chgflows.
1999 This statement shows that
1537.8
21
1273.3
41
3185.6
Capital One
has experienced positive net
-4512.6
6033.8
cash flow in0.0each of the last three years.
-9.8
82
-53.7
It has also had a net outflow of cash to fund its growth via investment cash which has been paid
for mostly by financing cash flows. Overall, the company looks to be in a good cash position.
Despite the firm’s expansion, it continues to hold a net positive cash flow.
VI. VALUATION
After analyzing the financial statements of the firm, it is now necessary to examine the
equity value of the firm in order to find any miss pricing. In order to detect any discrepancies in
stock value, the analysis will now look at relative valuation, a dividend discount model, the
capital asset pricing model, and finally a P/E multiple model.
A. Relative Valuation
In terms of relative value, Capital One seems to be undervalued. Exhibit 11 shows the
performance of the firm compared to it closest competitor, American Express, the credit lending
industry, and also the S&P 500. The first notable ratio is the P/E ratio of $11.84 which is well
below American Express, the industry, and the market. This could be a sign of an undervalued
Capital One Financial Corp
11/29/2004
16
Derek W. Smith
firm, but it could also be priced cheaper for a reason, so it is necessary to look further into the
numbers to see if this discrepancy is justified.
Exhibit 11
Capital One Amer. Express
ROA
3.1%
1.9%
ROE
20.3%
21.4%
Net Profit Margin
15.4%
11.9%
Price/Book
$
2.83 $
4.41
Price/Earnings
$
11.84 $
21.18
EPS
$
6.56 $
2.63
* Credit Lending Industry
** S&P 500
Industry*
1.1%
20.8%
13.3%
$ 3.02
$ 15.41
$ 3.10
Market**
2.1%
12.4%
6.2%
$ 2.60
$ 22.37
$ 1.28
Next, we look at the Earnings-Per-Share for the firm. This number is also well above
American Express, the industry, and the market. This shows that the company is actually
earning more profit for its stock holders and may actually be a more valuable stock. This is
contrary to the low P/E ratio and further shows a possible under pricing of the stock.
The final important thing to look at on a relative basis is the returns of the company. In
term of return on assets, Capital One is fairing better than its peers. This may be indicative of a
company with above average operations. Additionally, the net profit margin for the firm also
beats its competitors and shows that the firm has a good hold on its expenses relative to its peers.
Last, the company seems to be in line with its peers in terms of return on equity and shows no
advantage to any of the competitors in this regard.
Overall, Capital One seems to be cheap in relative terms. It seems to be under priced
with strong returns to the investor and strong operations.
B. Dividend Discount Model
The first intrinsic value calculation we will look at involves the use of a proprietary
dividend discount model (see Model 1) created specifically for this analysis of Capital One. This
model utilizes a typical dividend discount approach for the first 5 periods followed by a residual
price at the end of the 5th year based on earnings growth and P/E ratios. This model was chosen
Capital One Financial Corp
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Derek W. Smith
as opposed to the typical DDM due to the fact that Capital One is still a relatively young
company and only issues an annual dividend of $0.11 currently. As a result, this model was
overly sensitive to growth and discount rate estimates. Exhibit 12 shows how the price of
Capital One changed drastically based on slight adjustments to the discount rate, all else being
constant and illustrates the fact that this was not a reliable valuation measure.
Exhibit 12
Simple Dividend Discount Model
Discount Rate
15.30%
15.35%
15.40%
15.45%
15.50%
Stock Price
$ 213.20 $ 106.60 $ 71.07 $ 53.30 $ 42.64
* This model assumed EPS growth of 15.25% annually, $0.11 Dividend,
and current EPS of $6.42
In the Capital One DDM, consensus growth rate estimates were obtained from Stock Val
in regards to Capital One, the Diversified Financial Industry, the Financial Sector, and the S&P
500. These estimates can then be modified by the user of the model to allow for different
assumptions. In this case, the current growth rate estimates were used. Next, Stock Val was
used to obtain risk free return rates, market risk premiums, and Capital One’s Beta. In this case,
the 30-Year T-Bond rate was used as the risk free rate to account for the longer holding period
and perpetual payout of stocks. Stock Val was finally used to obtain current price and dividend
information for Capital One and P/E and EPS data for COF, the industry, and the sector.
After of obtaining the data, the user then could adjust estimates to reflect differing
growth rates over the next 5 years. In this case, the model shows the slow change over the next 5
years of growth from the current Capital One growth estimate to that more similar to the growth
of the average diversified financial and financial firm.
Finally, the model can use the data and assumptions of the user to create an intrinsic
value for the stock. In this case, the value of Capital One is $83.55 which is slightly above the
current price of $80.00. This indicates that the stock of COF may in fact be under priced.
Capital One Financial Corp
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Derek W. Smith
C. Capital Asset Pricing Model
Using the standard Capital Asset Pricing Model (CAPM) yields a similar outcome (see
Model 2). In this particular model, the risk free rate is set equal to the 30-year T-Bond yield for
reasons stated above. All other values were obtained via Stock Val. In this case, the stock of
Capital One has a value of $90.79 which is above the current price of $80.00. Once again, this
indicates that COF equity may be under priced.
D. P/E Multiple Model
The final model used to compute the price was a P/E Multiple Model created for this
analysis (see Model 3). In this model, Stock Val was used to obtain information regarding P/E
and EPS for Capital One, the Diversified Financials Industry, the Financial Sector, and the S&P
500. The model then calculated the current price of Capital One if it were trading at the P/E
multiples associated with its peers. Then the user is given the ability to allocate the weight of
these P/E multiples to create an intrinsic value. In this case, the model used 25% of the current
COF P/E, 50% of the Diversified Financial P/E, and 25% of the Financial P/E. As a result, the
intrinsic value of Capital One was calculated to be $86.73 and is once again above the current
price of the stock.
E. Estimated Target Price
All of the 3 intrinsic value models used above indicate that Capital One is under valued
at the current time. However, all of these estimated values are just estimates, and none seems to
carry more weight than the others on the surface. Therefore, to calculate a 1-year target price for
the stock we will weight each stock price evenly to arrive at a target of $87.02.
Capital One Financial Corp
11/29/2004
19
Derek W. Smith
VII. RECOMMENDATION
After examining all of the data on Capital One, it is my recommendation to place a hold
on the stock. The company has many positive equity drivers going its way. These include the
seemingly low intrinsic value, relative under pricing of the stock, and sound financial position of
the company based on financial statements. However, there are also a few drawbacks that keep
the stock from being a solid buy rating. The first negative aspect of the company is the slow
growth in the credit card industry. This is the firm’s primary business at the moment and any
immediate growth must come from this segment. While the company claims to be expanding
and shows signs of doing so, it could be years before these acquisitions make an impact on the
profit of the company as they incorporate the new firms to their proprietary Information Based
Strategy. In the meantime, I think holding the stock to wait and see further expansion plans and
the incorporation of already acquired businesses can be seen. The second major drawback to the
stock is what seems to be earning manipulation by using the loan loss reserve. If the company is
in fact decreasing this reserve and not actually increasing the credit quality of their loan portfolio
it could spell disaster in the future. This is especially true if personal income does not increase to
help borrowers repay their credit card debt which was accumulated over the last quarter.
Capital One Financial Corp
11/29/2004
20
Derek W. Smith
Model 1
Advanced Dividend Discount Model
COF
Diversified Financials
Financials
S&P 500
Growth Rate Estimates
Current
High
Low
15.00%
25.00%
0.00%
13.61%
25.13%
13.58%
10.84%
12.70%
10.78%
5.00%
7.50%
5.00%
30-Year Govt Bond Yield
Market Risk Premium
Required Equity Return
COF Beta
COF Required Return
4.96%
5.47%
10.43%
1.56
16.27%
Current Stock Price
Current Dividend
Dividend Yield
$ 80.00
$ 0.11
0.138%
COF P/E
Div. Financial P/E
Financial P/E
Current
11.50
14.80
13.10
COF
Diversified Financials
Financials
Mean
Assigned
20.00% 15.00%
25.13% 13.61%
11.42% 10.84%
7.00%
5.00%
$
$
$
15-Year Mean Assigned
12.70
13.4
13.40
13.4
13.10
13.1
EPS
6.69
2.48
3.51
COF Growth Weight
Div. Financial Weight
Financials Weight
S&P Weight
Total Weight (=100%)
Total Growth
Dividend Value
Present Dividend Value
EPS Value
Present EPS Value
1
100.00%
0.00%
0.00%
0.00%
100.00%
15.00%
$ 0.13
$ 0.11
$ 7.69
$ 6.62
Intrinsic Value
$ 83.55
$
$
$
$
2
100.00%
0.00%
0.00%
0.00%
100.00%
15.00%
0.15
0.11
8.85
6.54
Year
3
80.00%
20.00%
0.00%
0.00%
100.00%
14.72%
$
0.17
$
0.11
$ 10.15
$
6.46
4
60.00%
20.00%
20.00%
0.00%
100.00%
13.89%
$ 0.19
$ 0.10
$ 11.56
$ 6.33
$
$
$
$
5
60.00%
20.00%
20.00%
0.00%
100.00%
13.89%
0.22
0.10
13.17
6.20
KEY
Stock Val Data Input
User Input
System Generated Data
Intrinsic Stock Value
Capital One Financial Corp
11/29/2004
21
Derek W. Smith
Model 2
Capital Asset Pricing Model
Risk Free Rate
4.96%
Market Risk Premium
5.47%
Beta (60 month)
1.56
Expected Return
13.49%
Today's Stock Value
$80.00
1-Year Target Value
$ 90.79
Model 3
P/E Multiple Pricing Model
P/E Ratio
Current
15-Year
11.50
12.70
COF
14.80
13.40
Diversified Financials
13.10
13.10
Financials
18.30
20.50
S&P 500
COF
Diversified Financials
Financials
S&P 500
EPS Growth
EPS
27.30%
$ 6.69
21.00%
$ 2.48
9.80%
$ 3.51
6.60%
$ 57.30
COF EPS Relative Price
$ 80.00
Current Price
$ 89.65
Price @ Div. Fin P/E
Price @ Financials P/E $ 87.64
$ 137.15
Price @ S&P 500 P/E
Intrinsic Value Price
Weight
25%
50%
25%
0%
$ 86.73
Capital One Financial Corp
11/29/2004
22