After last year’s crash, things are going Charles Schwab’s way. Are value stocks still a buy?

Charles Schwab (BL 1.44%) We experienced difficulties in a high interest rate environment. Schwab has seen significant deposit outflows since the Federal Reserve began raising interest rates amid inflationary pressures in March 2022, leading the company to tap the Federal Home Loan Banks (FHLBs) and other resources to smooth out outflows.

Schwab’s deposit outflows have slowed in recent months, and we saw the same in the fourth quarter. With the stock up 37% from last May’s low and prospects for a 2024 rate cut on the table, is Schwab’s stock still a buy?

Charles Schwab’s strengths make it vulnerable during rising interest rates.

Charles Schwab has been providing investors with solid returns for decades thanks to its limited credit exposure and cost-effective business model. Financial services companies have historically relied on low-cost deposits that have delivered returns on equity that are higher than their peer averages.

As a critical component of its business model, Schwab relies heavily on deposits, many of which are held in savings accounts that customers have not yet invested in, generating high profits. This has served the company well over the past decade, but Charles Schwab has also struggled during periods of rising interest rates.

Beginning in 2017, the Federal Reserve began gradually increasing the federal funds rate, which ultimately created a problem for Charles Schwab called ‘customer cash sorting.’ Instead of keeping deposits in low-yield accounts, many customers have moved their funds into high-yield savings, CDs or relatively safe assets with attractive yields, reducing their balance sheets and much of the low-cost funds they rely on.

So when the Federal Reserve began raising interest rates in March 2022, Schwab again faced the problem of segmenting customer cash. The difference this time was that interest rates were rising in response to inflation, which was rising year over year at the fastest rate in 40 years.

Schwab’s deposit outflows have slowed significantly.

From August 2022 to March 2023, Charles Schwab lost deposits due to customer cash classifications at a rate of $5.6 billion per month as yields on other safe short-term assets, such as savings accounts and certificates of deposit, rose. This pressure on deposit outflows has slowed significantly since the local banking crisis. From June to December last year, Schwab’s deposits continued to decline, but at a monthly pace of $1.1 billion.

Chart by author.

Schwab’s outflows are moderating, thanks in large part to the Federal Reserve’s recent halt to its interest-rate hike campaign. With interest rates easing and likely cutting, Schwab could see deposit pressure starting to ease. This would be a welcome sign for companies looking to cut back on high-cost funding sources such as retail certificates of deposit and FHLB advances.

Is Charles Schwab stock a buy?

Charles Schwab is still managing to outflow, and the company’s main risk is that interest rates remain higher for longer than expected. This could lead to more outflows and put pressure on share prices. However, it seems more likely that interest rates will fall. According to CME The market is pricing in five rate cuts by the end of the year, according to the FedWatch tool.

SCHW PE Ratio Data from YCharts

Considering the prospect of interest rate cuts, Charles Schwab’s valuation seems quite reasonable. The stock trades at a price-to-earnings ratio of 24.6, which is close to its 10-year average. However, based on one year forward earnings, it is only 14.2.

Given its reasonable valuation, Charles Schwab looks like a good stock to buy today and add to throughout the year if interest rates actually fall, which could put significant pressure on its declining deposit base.