Canada's Challenger Bank
Hello friends and enthusiasts 👋,
The banking sector isn’t usually hailed as home to many growth stocks. Most bank stocks usually underperform the market in the long run according to some data. But what if I told you I found an outlier?
A bank with no branches that you’ve probably never heard of that has outperformed massive tech companies like Adobe and Salesforce by over 80% in the past five years.
Say hello to EQ Bank. (8 min read)
Today at a glance:
A Banking Oligopoly
Canada’s Challenger Bank
Valuing a Bank Stock
A Banking Oligopoly
When it comes to the Canadian banking system, just five banks control close to 90% of the market: Royal Bank of Canada (RBC), Bank of Montréal (BMO), Canadian Imperial Bank of Commerce (CIBC), Bank of Nova Scotia (Scotiabank), and Toronto-Dominion (TD). These five banks alone manage over CA$7.25 trillion in assets, and in size, hold 3% of all worldwide banking assets.
Banking in particular is an interesting sector and it’s a very important part of the global economy. Unlike companies, banks that end up being too big and fail can devastate or even crash entire economies. JPMorgan, the largest bank in the world, holds over $4 trillion in assets alone, yet only accounts for an 8% market share in US banking (compared to Canada’s big five that hold close to 90% like mentioned above).
As of 2022, Canada’s banks paid over $26 billion in dividend income to Canadians and the Canadian financial sector alone accounts for nearly 4% of the country’s $2 trillion GDP.
Enter, EQ Bank.
Canada’s Challenger Bank
EQ Bank or EQB Inc (TSE: EQB), is an online-only bank headquarted in Toronto, Canada dedicated to challenging the monopolistic grip on the Canadian banking market. It’s very similar if not identical from SoFi or Ally Bank, which are both also online-only banks, but based in the US.
EQ has risen to be the 7th largest domestic bank in Canada since its founding in 1970, and both indirectly and directly serves 6 million customers with combined assets worth over CA$110 billion (600,000 of those being EQ Bank customers depositing CA$31 billion in 2023).
One of EQ Bank’s notable perks is it allows all of their customers to withdraw at any ATM in Canada for no cost while earning cash back on their spending. Being a digital bank with no physical branches has helped EQ keep costs down dramatically compared to many of the big banks who had to cut jobs due to rising inflation. In 2021, 2022, and 2023, EQ was named Canada’s best bank by Forbes.
But, of course, that's not even the best part. The best part is EQ’s stock has surged over 150% in the past five years.
When spotting companies, one of the main factors should always be its moat; its competitive advantage. In this case, EQ seems to have almost no moat at all. Since 90% of the market is controlled by five banks, that leaves EQ almost no room to grow. In fact, EQ’s $3 billion market cap is the same as Royal Bank’s quarterly net income, and as a percent of the Canadian banking market, EQ controls just a 1.09% share1.
But let's look a little deeper into their fundamentals.
Year-over-year (from 2023), EQ banking customers increased by 30%, commercial loans increased 31%, and they also raised their dividend by 25%. EQ also grew its net income by 11.2% in this same time frame when the big banks had a 23% drop. For 2024, earnings growth is expected to be 15-20%, which is by far beating the average market return of 8-10%.
EQ also has a very reasonable ROIC2 of 17% over the past five years. This is a fairly good ROIC. It’s not a very meaningful one, but it’s also not one to laugh at. Remember, ROIC is how much a business is making for the money you invest into them. This means EQ is consistently making close to $20 on every $100 of your capital, which is not bad for a company of this size. It only gets better when we look at their CAGR3. CAGR over the past 5 years is hovering at 30% which is over 2x the market in the same time frame and 56% more than JPMorgan (sometimes considered to be the best performing bank stock).
In all cases, EQ Bank really has no moat, but with a very high industry growth rate, and a high customer base growing at hundreds per day, they’re positioning themselves to be a notable competitor in online banking far in the future.
Now these metrics sound great, but how do you know if EQ is at a good price? Is EQ worthy of adding to your portfolio? And how do you value a bank stock anyway?
Valuing a Bank Stock
Unlike traditional companies like Hershey’s or Apple, using a discounted cash flow analysis (DCF) is not the right way to value a bank stock since free cash flow is usually low and unpredictable with banks.
For valuing banks and even insurance companies, a popular way is using a metric called free cash flow to equity. Similar to the DCF analysis where you are trying to determine how much today’s cash flows are in the future, FCF to equity is determining how much equity the company could have in the future to pay us those cash flows even if they don’t end up doing so. Generally, bigger banks will pay us this cash through dividends in the future since they have no more room to grow, but when it comes to a smaller bank like EQ, they usually have a low or no dividend at all to reinvest the cash back into the business.
In fact, EQ is a great example of this as they only have a 15% payout ratio. This means that of all their cash, just 15% is paid out as dividends to shareholders. The rest is reinvested right back into growing the business which explains their impeccable track record over the past few years.
I myself don’t believe it’s worth spending so much time on coming up with an FCF to equity formula, and instead, look for a metric called the price-to-tangible book ratio (P/TBV) which is the standard for valuing banks. The P/TBV is what you as the shareholder can expect to receive if a bank or financial company were to go bankrupt, divided by its share price. Unlike price to book ratio (P/B), P/TBV does not include any assets that cannot be sold upon bankruptcy; it only includes liquidable or “hard” assets.
When a bank’s stock drops below a P/TBV of 1.00, that bank is considered undervalued since you’re paying less than what the bank would owe you as the shareholder upon collapse. Anything above and you’re paying more, which is something to avoid in most cases.
Warren Buffett was notorious for buying loads of Bank of America stock during the 2008 financial crisis because the bank was trading at a P/TBV of less than 0.5. Bank of America is currently Buffett’s second-largest holding.
Looking at EQ, they’re currently trading at a 1.12 P/TBV. This means (in essence), that EQ is trading at a 12% premium. Some could argue that EQ’s growth for the future almost disregards this premium (which I could agree with), but I’ll leave that to subjectivity.
Thanks for reading today’s Deep Dive! I’ll be back in your inbox this Friday for yet another Weekly Brief. You can read my Blossom Social post covering EQ Bank here (the post is heavily edited to fit into a 5,000 character limit).
Happy investing, and again, thanks for reading!
☕️ - Jacob xx
Calculated using EQ Bank’s $3 billion in revenue divided by Canada’s banking market size of roughly $275 billion.
Return on invested capital (ROIC): the amount a business is returning you annually for the dollar amount you’re investing.
Compound annual growth rate (CAGR): a metric to determine how much a stock’s price has returned every year over a certain period of time. (CAGR can also be used to determine revenue growth, profit growth, etc.)
excellent post buddy, keep it coming