Why Warren Buffett loves Ally Financial (NYSE:ALLY)

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Thesis

Berkshire Hathaway Inc.’s (BRK.A, BRK.B) SEC 13F filing for the June quarter revealed that Warren Buffett is betting big on Ally Financial Inc. (NYSE: ALLY). Buffett increased his stake in the 234.47% company, now valued at approximately $390 million, and with a 9.7% stake in the company. This makes Berkshire one of Ally’s major shareholders. Is there a thesis of value? The short answer is yes. Ally is trading at a one-year forward P/E of around x5 and a P/B of less than x1. Personally, I think Ally should be valued at around $66.14/share and I see around 85% upside. I anchor my thesis on the results of a residual earnings model based on analyst consensus EPS estimates through 2025.

For reference, Ally stock is down about 35% year-to-date, compared to a nearly 15% loss for the SPX.

About Ally Financial

Simply put, Ally is primarily focused on sourcing, structuring, and operating automotive loans and finance throughout the loan cycle. In recent years, Ally has also launched digital banking initiatives and managed to accumulate a substantial number of consumer deposits.

Ally Financial is one of the largest auto lenders and bank holding companies in the United States. The company was founded by General Motors (GM) in 1919 and was a subsidiary of GM until 2006, shortly before the company had to be bailed out following the financial crisis by the US government.

The Company operates four key segments: auto finance, insurance, corporate finance and mortgage finance. Auto finance is by far Ally’s largest and most important segment, accounting for approximately 65% ​​of total sales. Insurance ranks second with about 20% of revenues. Corporate Finance and Mortgage Finance each represent just over 5% of sales. Ally Financials primarily operates in the United States.

Attractive Fundamentals vs Valuation

Ally’s finances are very strong – so it’s easy to see why Buffett likes the title. From 2018 to 2021, Ally’s revenue grew from $7 billion to $8.9 billion, with a 3-year CAGR of approximately 8%. Over the same period, net income more than doubled: from $1.5 billion in 2018 to $2.9 billion in 2021 (33% margin). Ally has not experienced a major downturn amid recent macro developments. For the last 12 months, the company generated revenues of $9.4 billion and net income of $2.7 billion (28% margin).

As a “bank”, Ally’s balance sheet is not overleveraged. As of June 2022, Ally had $140.4 billion in customer deposits and $129.3 billion in total loans. Total assets were valued at $185.7 billion.

Despite strong finances, Ally is trading relatively cheap. The stock’s one-year forward P/E is estimated at x5 and the P/B x0.9. these multiples are not only lower than the industry average, but also lower than the historical average of All’s trading multiples over the past 5 years. According to Bloomberg data as of August 17, Ally’s P/E multiple against industry peers is 1.5 standard deviations below the historical 5-year average and relative to the historical Ally, the multiple is trading at a discount of 1.7 standard deviation, indicating 30% upside.

ALLY Valuation

Looking for Alpha

Valuation of residual profits

In my opinion, banks are the best candidates to be assessed with a residual earnings (“RE”) assessment, since the RE framework anchors both the income statement and the balance sheet as well as the accounting of exercise. That said, I apply the following assumptions:

  • To forecast EPS, I rely on consensus analyst forecasts available on the Bloomberg Terminal through 2023. In my opinion, any estimate beyond 2023 is too speculative to be included in a valuation framework – in especially for banks.
  • To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the S&P 500 to find the stock’s beta. For the risk-free rate, I used the yield on 10-year US Treasuries as of August 15, 2022. My calculation indicates a required fair return of about 10%.
  • To calculate Ally’s tax rate, I extrapolate the 3-year average effective tax rate from 2019, 2020, and 2021.
  • For the terminal growth rate, I apply 3% percentage points, approximately nominal GDP growth, which I believe is a fair assumption for an industry leader.

Based on the assumptions above, my calculation returns a benchmark target price for Ally of $66.14/share, implying a significant upside of over 85%.

Ally Valuation Residual gains

Consensus of BPA analysts; Author’s calculation

I understand that investors may have different assumptions regarding Ally’s required return and ultimate business growth. Thus, I am also attaching a sensitivity table to test different hypotheses. For reference, red cells imply overvaluation relative to the current market price, and green cells imply undervaluation.

Sensitivity Table Allies Valuation

Consensus of BPA analysts; Author’s calculation

Risks

While I believe investing in banks is less risky than the market implies, tail risk exposure is still high and, if materialized, could depreciate Ally’s share price significantly. . Remember, during the Great Financial Crisis, Ally needed to be bailed out by the government. Therefore, despite Ally’s cheap valuation, investors should not ignore news that may indicate adverse developments for Ally.

Conclusion

Warren Buffett likes to chase quality companies at a reasonable price. And Ally Financials matches the screen. Considering Ally’s fundamentals relative to its valuation, it’s no surprise that the Oracle of Omaha took a 9.7% stake in the company, as Ally shares trade very cheap. Personally, I think Ally shares should be valued at $66.14/share. Strong purchase.

About Mary Moser

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