Framework Security Analysis

Security Analysis: J.P. Morgan Chase and Co.

THE THEME

The purpose of this project is to recommend a stock based on a stock market analyst’s perspective using industry and company analysis, stock performance history, and stock performance expectations, while taking into consideration the current macroeconomic environment. The industry that is in the forefront of the current economic downturn and has suffered inordinate losses is the financial sector. J.P. Morgan Chase & Co. (JPM), the company this report is profiling, is emerging relatively unscathed in comparison to many other companies in this sector. It is now one of the top three banks in holdings in United States, along with Bank of America and Citigroup. James Dimon became J.P. Morgan’s CEO following the merger with Bank One. He was a protégé of Sandie Weill, the visionary mastermind behind the formation of Citigroup. James Dimon has succeeded in morphing J.P. Morgan into a financial services supermarket serving both individuals and institutions.

J.P. Morgan’s stock closed on Friday September 26, 2008 at $47.82 on a 52 week range of $29.24 low to $49.95 high. As will be seen from our analysis in the stock valuation section of this paper, we believe this is an inaccurate representation of J.P. Morgan’s intrinsic value. Further, the stock valuation will provide a foundation upon which our investment strategy is based.

BUSINESS ANALYSIS

Profile of J.P. Morgan Chase & Co.

J.P. Morgan’s serendipitous fortune in the latest economic crisis emerged primarily due to Dimon’s risk aversion and his preoccupation with the merger of Bank One in 2004, which forced him to stay in the sidelines of the subprime boom. Following the subprime market’s collapse and its cascading effects in the financial sector, the new banking world is comprised of two camps, the ones who are trying to survive and climb out of the financial annihilation and the few who are trying to profit from it. J.P. Morgan finds itself now with a strong balance sheet, a capacious amount of capital and an elevated sense to dominate. This became apparent when it was approached by the Treasury Department to acquire Bear Stearns in a fire sale as Bear Stearns was collapsing. J.P. Morgan now has a chance to increase its market share by acquiring competitors, while its rival Citigroup is selling assets and it is trying to raise capital in order to survive and as Bank of America is preoccupied in absorbing Countrywide and Merrill Lynch.

MACROECONOMIC AND INDUSTRY ANALYSIS

The macroeconomic analysis explores the implications of some of the variable components of the Index of Leading Indicators (ILI) who serve the purpose of forecasting or giving some indication of expected future economic activity. These variables tend to turn downward before a recession and upward before an expansion. In the last forty-two years, they have accurately forecasted seven recessions, however they have also forecasted five recession that never materialized. This demonstrates some of the limitations of using ILIs as a forecasting tool. The overall health of the economy has a significant impact on the performance of the companies in which it operates. A growing economy tends to provide more opportunities for expansion and increased profitability where an economy that is contracting provides a more difficult operating environment as well as lower profits.

U.S. Real GDP Growth Rate Forecast

Expected monthly short-term economic conditions (seasonally adjusted):

Month	Date	Forecast Value	50% Correct +/-	80% Correct +/-
0	Jul 2008	1.70	0.00	0.00
1	Aug 2008	1.70	0.79	1.30
2	Sep 2008	1.70	0.97	1.61
3	Oct 2008	1.60	1.10	1.81
4	Nov 2008	1.60	1.20	1.98
5	Dec 2008	1.60	1.28	2.11
6	Jan 2009	1.40	1.35	2.23
7	Feb 2009	1.40	1.42	2.34
8	Mar 2009	1.40	1.47	2.43

The real GDP is a measure of the total production of goods and services in an economy and is a reflection of an expanding or contracting economy. The traditional defining condition of a recession is considered to be two consecutive quarters of negative real GDP. However, the National Bureau of Economic Research (NBER) defines recession in broader terms as “a significant decline in economic activity that spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail.” A sustained recession has the potential to become a depression, even though the distinction between the two is not clearly defined. A decline of 10% or more in real GDP is said to constitute a depression. According to Bureau of Economic Advisors ( www.bea.gov ), during this first quarter of this year, the economy grew at 0.9 percent and subsequently, during the second quarter it grew at a 3.3 percent annual rate. The second quarter’s growth was attributed largely to upward revisions of net exports and investment inventories. The projected GDP according to the Financial Forecasting Center ( www.forecasts.org ) should range in the area of 1.7 to 1.4. However, for the next few months, there is a strong negative sentiment among economists like Stephen Stovall, S&P’s chief investment strategist. He is forecasting a decline of 0.5% for the fourth quarter of this year and 0.7% decline for the first quarter of next year, which would indicate that the economy is sliding into a recession. There is also much speculation in the news media that failure to contain the current credit crises could cause a much deeper recession.

U.S. Civilian Unemployment Rate Forecast

Expected monthly short-term economic conditions:

Month	Date	Forecast Value	50% Correct +/-	80% Correct +/-
0	Aug 2008	6.10	0.0	0.0
1	Sep 2008	6.2	0.3	0.5
2	Oct 2008	6.3	0.4	0.6
3	Nov 2008	6.4	0.4	0.7
4	Dec 2008	6.5	0.4	0.7
5	Jan 2009	6.7	0.5	0.8
6	Feb 2009	6.8	0.5	0.8
7	Mar 2009	7.0	0.5	0.9
8	Apr 2009	7.1	0.6	0.9

The Bureau of Labor Statistics measures monthly the percentage of the total labor force that is unemployed in the U.S. as representative of the percent of people who are not working, but who are actively seeking employment for pay. The unemployment rate serves as a measure of the level of operating capacity within an economy. In the month of August, the unemployment rate rose from 5.7 percent to 6.1 percent. Non-farm employment trended downward as did manufacturing and employment services whereas health care and mining added jobs. The forecasted U.S. unemployment rate is expected to steadily increase by over 7 percent by the end of the forecasted period according to Financial Forecasting Center ( www.forecasts.org ).

S&P 500 Stock Index Forecast

Expected monthly short-term economic conditions:

Month	Date	Forecast Value	50% Correct +/-	80% Correct +/-
0	Aug 2008	1,282.830	0.00	0.00
1	Sep 2008	1,294.00	129.72	214.36
2	Oct 2008	1,253.00	159.70	263.91
3	Nov 2008	1,253.00	180.36	298.04
4	Dec 2008	1,313.00	196.62	324.91
5	Jan 2009	1,322.00	210.23	347.40
6	Feb 2009	1,277.00	222.05	366.93
7	Mar 2009	1,258.00	232.56	384.30
8	Apr 2009	1,182.00	242.07	400.01

According to Bodie, Kane, and Marcus, the authors of our course textbook, Investments, the S&P 500 stock price index weighs in its performance not only the ratio of stock to earnings but also the inflation rate, interest rates, risk, and other macroeconomic variables. As such, the above forecast from the Financial Forecasting Center ( www.forecasts.org ) reflects a temporary increase in return based on the actual S&P close of 1,213.59 from September 16, 2008. The forecast then estimates that will be followed in the next seven months by a decline of the S&P 500 to 1,182.00 by April 2009. Currently, the S&P is being negatively impacted by the bankruptcy of Lehman’s, the sale of Merrill Lynch to Bank of America, and the liquidity troubles of AIG with its ultimate purchase by the government.

U.S. Inflation Rate Forecast

Expected Monthly Short-Term Economic Conditions:

Month	Date	Forecast Value	50% Correct +/-	80% Correct +/-
0	Aug 2008	5.70	0.0	0.0
1	Sep 2008	5.2	0.5	0.9
2	Oct 2008	4.5	0.7	1.1
3	Nov 2008	4.0	0.7	1.2
4	Dec 2008	3.6	0.8	1.3
5	Jan 2009	3.4	0.9	1.4
6	Feb 2009	3.4	0.9	1.5
7	Mar 2009	3.4	1.0	1.6
8	Apr 2009	3.4	1.0	1.7

The inflation rate is determined using the Consumer Price Index (CPI) calculated by the Bureau of Labor Statistics utilizing 100 as the base and 1982 as the year. The CPI is an average of the prices of consumption that a family of four would expend for a “basket” of goods and services. This serves as a reflection of that family’s purchasing power. Alternately, inflation is an indicator of the level of decline in purchasing power and it reflects the loss in the value of money. The inflation rate in August, according to www.inflationrate.com , was 5.37% which is substantially higher than the 2% to 3% representative of a healthier, expanding economy. Anytime inflation climbs above 5%, it begins to stifle the economic growth, becomes more stressful for consumers, and it impacts consumption negatively. The forecasted value, according to Financial Forecasting Center ( www.forecasts.org ), shows a drop in expected inflation over the next few months and then it is expected to level off by next April to a more manageable rate of 3.4%. According to S&P economists, the inflation next year will moderate to 2.4% and further drop to 2.1% and 2.0% in 2010 and 2011, respectively. However, high growth rates in the money supply are attributed to causing higher rates of inflation. Currently, the government is increasing the money supply in an attempt to provide additional liquidity in the system. They are hoping that this will calm the credit markets that are in the midst of a credit crisis but the downside risk is that their very efforts could cause inflation rates to increase.

Federal Funds Interest Rate Forecast

Effective Interest Rate: Percent Monthly Average:

Month	Date	Forecast Value	50% Correct +/-	80% Correct +/-
0	Aug 2008	2.000	0.00	0.00
1	Sep 2008	2.00	0.62	1.03
2	Oct 2008	2.00	0.76	1.26
3	Nov 2008	2.00	0.86	1.43
4	Dec 2008	1.75	0.94	1.55
5	Jan 2009	1.75	1.01	1.66
6	Feb 2009	1.75	1.06	1.75
7	Mar 2009	1.75	1.11	1.84
8	Apr 2009	1.75	1.16	1.91

The Federal Funds Rate is the rate at which banks lend money to each other via the Federal Reserve usually for overnight usage. The reason banks use this utility is due to the fact that by law, they are required to maintain a certain level of reserves with the Federal Reserve. The Federal Reserve sets the target rate through its open market operations and is the tool that it uses to regulate the money supply in the U.S. economy. Changes in the target rate impact the value of the dollar and affect the amount of lending to fund new economic activities. During recessions and periods of low economic activity, the Federal Reserve often lowers its target rate. Historically, the lowering of the rate has predated recessions. The Financial Forecasting Center is projecting a drop in the rate in December to 1.75 from the current 2.00. However, the longer-term expectation of many economists is that the Federal Reserve will increase the rate as soon as possible after the end of the year in order to restrain inflation.

Consumer Confidence

The Index of Consumer Sentiment serves as an important indicator of future economic performance as it reflects the measure of optimism or pessimism with which consumers and producers view the economy. Despite a recent decline in gas prices, lower employment and a very grim outlook on personal finance has created the weakest buying expectations experienced in the last thirty years. This has pushed the consumer confidence measure down to 63.0 in the month of August, from 83.4 a year ago and a peak at 96.9 in January of 2007. The data indicate that the growth of consumer spending will near zero in the fourth quarter of this year and first quarter of next year, which is a strong indication of the level of pessimism about the economy among consumers and producers. It is also a possible warning sign of a recession.

Bank Industry Analysis

According to Value Line, the banking industry had a very poor second quarter this year and was hurt by asset write-downs, dilutive stock issuance, and surging loan losses. Not much overall improvement is anticipated until late 2009 while the possibility remains that the current problems within the industry could limit long-term growth. It is highly likely that rising credit costs and unemployment will impede consumers’ ability to repay mortgages, auto loans, credit cards, and home equity loans. The weaker economy will also further decrease the demand for loans and other bank services, while mortgage activity is not expected to rebound in the near future. Higher credit costs will also squeeze banks margins and further impact the growth of their net interest income. Additionally, there are signs of problems arising within the commercial borrowing sector. The industry is also negatively impacted by the economic slowdown and the breakdown of the fixed-income markets. As pressure increases for more regulatory oversight and legislation along with additional corrective measures for the current economic crisis, it is possible these could further hinder and prolong the time it take this industry to recover. Some banks have had to issue additional stock to shore up their equity positions which may prevent them from improving their earnings per share in the next three to five years back up to the pre-crisis levels. In regards to timeliness, the industry is rated an unfavorable ranking of 97 on scale of 1 representing the best and 99 the worst score. Some banks may recover by 2011 to 2013, but it is believed the overall the industry will remain volatile in the near future. Generally, investing in the industry for most investors would not be recommended at this time. More risk tolerant investors who want to diversify their holdings by including banks in their portfolio they may consider investing in some of the stronger banks who have been unfairly penalized for others mistakes.

Conclusion: Macroeconomic and Industry Analysis

Based on our analysis of the above macroeconomic factors, it is our belief that the economy is currently in a recession or is about to enter into one beginning in the fourth quarter of this year and first quarter of next year. The macroeconomic conditions are very fluid because of the dynamic cascading effect of the current crisis through the economy and global markets. The speed at which our economy is going to recover is extremely hard to predict. Based on the data that we have been able to analyze, we are forecasting that recovery may begin by the middle of next year so long as the Federal Reserve is able to put a hold on inflation. If not, there is a potential that the economy will stall into stagflation. The longer-term outlook is that economy should be able to regain its footing and start expanding again.

The Banking Industry will be very slow in its recovery compared to the rest of the economy and more than likely will experience major consolidation where a lot of the banks will not survive the existing storm in their current state. A very recent prime example of this involves J.P. Morgan wherein they purchased Washington Mutual. However the larger, more solid banks will be able to profit from the current woes of their competitors and will experience a faster recover and emerge bigger and more stable.

COMPANY ANALYSIS: ITS PROSPECTS, MAJOR PRODUCTS, AND SERVICES

J.P. Morgan Chase & Co is a global financial holding company that provides a variety of financial services and operates through six business segments: investment banking, retail financial services, card services, commercial banking, treasury and security services, and asset management division. Approximately 60% to 75% of its profitability is generated from its investment banking, retail financial services, and card services operations.

The investment banking division offers a variety of investment banking products and services such as securities underwriting in equity and debt markets, corporate strategy and structure advisory services, risk management, trading platforms for institutional clients in cash securities, and derivatives and research. Its client base includes corporations, governments, financial institutions, and institutional investors.

The retail financial services division of J.P. Morgan offers retail banking such as checking and savings accounts, mortgage banking, and consumer lending products such as auto financing, home equity loans, business loans, and investment services available through its branches.

The card services operations issues credit cards and has a platform for processing both Visa and MasterCard payments through a joint venture with First Data Corporation. It has in circulation 155 million credit cards and is one of the largest card operators in the industry. This division is extremely profitable producing returns on equity of 21% in 2007 and 23% in 2006.

The commercial banking offers lending and asset management services to financial institutions, corporations, and municipalities. The treasury and securities services division provides cash management, liquidity products, investments, and information services. Finally, the asset management division offers wealth management services and investment services to high net worth individuals, retail investors, and institutions.

FINANCIAL ANALYSIS

J.P. Morgan Chase (JPM) is a well-diversified financial institution that derives its income from a variety of banking disciplines. Given these banking disciplines, JPM has been able to diversify its portfolio to sustain a competitive advantage within the financial marketplace. This section of our analysis will illustrate JPM’s financial health and profitability versus the banking industry and specifically, its primary competitors. Furthermore, we will illustrate our growth projections of JPM’s revenues and earnings for the remaining two quarters of 2008 (3rd quarter & 4th quarter) as well as for the next five years (2009-2013). Our growth projections are based on JPM’s past growth averages, and more notably, their ability to adapt to the future macroeconomic conditions described previously in the industry analysis.

Financial Health

JPM’s financial health can be determined by examining a few financial ratios that can depict the company’s heart-rate at any given point in time. The following table and charts illustrate JPM’s tier 1 capital ratio, loans to total assets, and its loan loss reserve ratio from 2005 until 6/30/08. Furthermore, the table illustrates JPM’s aforementioned ratios relative to the industry average as well as its primary competitors (largest banks average). The largest bank averages consist of information gathered from Bank of America, Citigroup, Wachovia, Wells Fargo, and SunTrust Bank. The tier 1 capital ratio is the core measure of a bank’s financial strength, as it is the ratio of a bank’s core equity capital and disclosed reserves to its risk-weighted assets. The loans to total assets percentage is primarily a measure of liquidity, wherein a higher ratio reflects less liquidity. Loans are typically long-term investments that restrict a bank’s ability to quickly convert assets to cash. The loan loss reserve ratio is an allowance for potential loan defaults; therefore, a variation in this ratio could signal changes in the credit markets.

Financial Health Ratios
	2005	2006	2007	3/31/2008	6/30/2008
Tier 1 Capital Ratio	8.50%	8.70%	8.40%	8.30%	9.10%
Industry Average	8.01%	8.15%	8.02%	7.95%	8.04%
Largest Banks Average	8.43%	8.73%	7.19%	7.81%	8.47%
Loans to Total Assets	34.37%	35.21%	32.66%	31.98%	29.55%
Industry Average	63.25%	63.60%	65.83%	66.33%	67.33%
Largest Banks Average	45.00%	48.50%	48.40%	47.00%	47.00%
Loan Loss Reserve Ratio	1.70%	1.50%	1.80%	2.18%	2.47%
Industry Average	1.05%	1.09%	1.20%	1.29%	1.41%
Largest Banks Average	0.62%	0.55%	1.00%	2.56%	2.00%

Tier 1 Capital Ratio Chart Analysis

As illustrated, JPM’s tier 1 capital ratio has remained relatively stable and higher than its competitors since 2007, which illustrates that the company has been able to effectively retain its financial strength in an extremely volatile market.

JPM's Tier 1 Capital Ratio versus Industry

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

2005200620073/31/20086/30/2008

JPM's Tier 1 Capital Ratio

Industry Average

Largest Banks Average (BAC, C, WFC)

Loans to Total Assets Chart Analysis

As seen in the chart below, JPM’s loans to total assets percentage has remained lower than its competitors since 2005. This likely indicates that the firm is better equipped to handle a liquidity crisis than its competitors.

JPM's Loans to Total Assets versus Industry

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10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

2005200620073/31/20086/30/2008

JPM's Loans to Total Assets

Industry Average

Largest Banks Average (BAC, WB, STI, WFC)

Loan Loss Reserve Ratio Chart Analysis

As depicted, JPM’s loan loss reserve has been increasing since 2006, which illustrates that this company as well as its competitors are addressing the credit crisis by building higher reserves to account for higher loan defaults.

JPM"s Loan Loss Reserve Ratio versus Industry

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

2005200620073/31/20086/30/2008

JPM's Loan Loss Reserve Ratio

Industry Average

Largest Banks Average (BAC, WB, STI, WFC)

Profitability

JPM’s profitability can be determined by examining a few financial ratios that can illustrate the company’s ability to generate cash flow. The following table and charts illustrate JPM’s total revenue, total net revenue (less interest expense), net interest income, net income, net interest margin, profit margin, return on assets, return on equity, and EPS-diluted from 2005 until 6/30/08. Furthermore, the table illustrates the company’s aforementioned ratios relative to the industry average as well as its primary competitors (largest banks average). The largest banks averages consist of information derived from the financial information of Bank of America, Citigroup, Wachovia, Wells Fargo, and SunTrust Bank.

Profitability Ratios
	2005	2006	2007	3/31/2008	6/30/2008
Total Revenue	$79,902	$99,302	$116,353	$26,763	$26,634
Total Net Revenue	$54,533	$61,437	$71,372	$16,890	$18,399
Net Interest Income	$19,831	$21,242	$26,406	$7,659	$8,294
Net Income	$8,483	$14,444	$15,365	$2,373	$2,003
Net Interest Margin	2.19%	2.16%	2.39%	2.59%	2.71%
Profit Margin	10.62%	14.55%	13.21%	8.87%	7.52%
Return on Assets	0.70%	1.10%	1.10%	0.61%	0.48%
Industry Average	1.19%	1.15%	0.74%	0.43%	0.67%
Largest Banks Average	1.17%	1.27%	0.96%	0.40%	0.40%
Return on Equity	8.00%	12.20%	12.90%	8.00%	6.00%
Industry Average	12.55%	12.20%	7.72%	4.61%	7.02%
Largest Banks Average	13.70%	13.80%	11.20%	4.50%	4.50%
EPS-Diluted	$2.38	$3.82	$4.38	$0.68	$0.54
Largest Banks Average	$4.12	$3.77	$2.13	$0.24	$0.25

Return on Equity Chart Analysis

As seen below, JPM’s return on equity steadily increased from 2005 through 2007, and has since declined due to the credit crisis experienced in the financial industry. Additionally, their competitors have also experienced declines from the credit crisis; however, the chart illustrates that their declines seemed to begin earlier than JPM’s. It should be noted that the firm has demonstrated its supremacy in stockholder’s return on equity versus its primary competitors (largest banks) since 2007.

JPM's ROE versus Industry

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2.00%

4.00%

6.00%

8.00%

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12.00%

14.00%

16.00%

2005200620073/31/20086/30/2008

JPM's ROE

Industry Average

Largest Banks Average (BAC, STI, WB, WFC)

EPS-Diluted Chart Analysis

As illustrated, JPM’s EPS-diluted steadily increased from 2005 through 2007, and has since declined similarly to return on equity due to the credit crisis in the financial markets. Additionally, the company’s primary competitors, Bank of America, Citigroup, and Wells Fargo have also experienced declines from the credit crisis; however, the chart illustrates their declines appeared to begin earlier than JPM’s. It should be noted that JPM has demonstrated its supremacy in delivering earnings to its stockholder’s versus its competitors since 2006.

JPM's EPS-Diluted versus Primary Competitors

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$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

$4.50

$5.00

2005200620073/31/20086/30/2008

JPM's EPS-Diluted

Largest Banks (BAC, C, WFC)

Projections

The following table details JPM’s past averages and growth rates for various financial health and profitability ratios.

Past Averages & Growth Rates
	1-Year	3-Years	5-Years
Total Revenue (Growth Rate)	17.17%	26.90%	22.45%
Net Income (Growth Rate)	12.57%	51.93%	48.69%
Profit Margin (Annual Average)	13.21%	12.79%	18.32%
Net Interest Margin (Annual Average)	2.39%	2.25%	2.22%
Return on Assets (Annual Average)	1.06%	0.95%	0.84%
Return on Equity (Annual Average)	12.86%	11.03%	10.88%
Loan Losses Reserve Ratio (Annual Average)	1.80%	1.67%	1.78%
EPS-Diluted (Growth Rate)	14.66%	41.37%	40.50%
EPS-Diluted (Annual Average)	$4.38	$3.53	$3.07

The table below displays our projections of revenue and earnings for JPM in the 3rd quarter 2008, 4th quarter 2008, and year-end 2008.

Projections of Revenue & Earnings for 3Q08, 4Q08 & 2008
	3Q08	4Q08	2008
Total Revenue	$27,650	$29,325	$110,372
Total Net Revenue	$18,250	$19,550	$73,089
Net Income	$2,054	$2,400	$8,830
Return on Assets	0.40%	0.50%	0.50%
Return on Equity	6.00%	6.50%	6.63%
EPS-Diluted	$0.48	$0.70	$2.40

The following table illustrates our growth rate projections of revenue and earnings for JPM for 2009 through 2013. It should be mentioned that the growth rates were calculated by using our projections of revenue and earnings for year-end 2008 from the previous table. We arrived at our projections by examining JPM’s past growth rates and averages as well as forecasting the impact that anticipated macroeconomic factors could have on the company.

Growth Rate Projections of Revenue & Earnings for 2009-2013
	2009	2010	2011	2012	2013
Total Revenue (Growth Rate)	8.72%	18.50%	20.27%	18.41%	16.22%
Total Revenue	$120,000	$155,000	$192,000	$217,000	$234,000
Total Net Revenue (Growth Rate)	29.09%	18.34%	15.55%	13.75%	13.02%
Total Net Revenue	$94,350	$102,350	$112,755	$122,346	$134,765
Net Income (Growth Rate)	67.05%	51.06%	43.18%	32.39%	28.07%
Net Income	$14,750	$20,150	$25,920	$27,125	$30,420
EPS-Diluted (Growth Rate)	50.00%	33.07%	25.55%	22.19%	18.00%
EPS-Diluted	$3.60	$4.25	$4.75	$5.35	$5.49

STOCK VALUATION

In order to calculate J.P. Morgan’s current intrinsic value, the Capital Asset Pricing Model (CAPM), Dividend Discount Models (DDM), and P/E valuation models were employed. The company’s equity cost of capital and fair value were determined using the rate available on the current 3-month Treasury bill rate as the risk-free rate, the average return of the S&P 500 for the past ten years as the return on the market, and the beta provided by Reuters.com. Given a 1.006% risk free rate and an average 10 year return on the S & P 500 of 4.675%, J.P. Morgan’s required return was calculated to be 4.27%. The Compound Annual Growth Rate (CAGR) formula was used to determine the growth rate of the company’s dividends over the past seven years and once the equity cost of capital was determined, the DDM was used to derive the per share price of the stock and the estimated value of the company. The share price was calculated by dividing the dividend by the difference between the required rate of return and the dividend growth rate. Given a dividend growth rate of 1.82% and a yearly dividend of $1.52 per share, J.P. Morgan’s computed intrinsic value is $213 billion with an estimated share price of $61.93 compared to the actual market price of $47.82 as of the close on Friday, September 26, 2008. According to our analysis, this would be a 19-34% discount to our estimated intrinsic value of the company depending on the valuation model chosen.

Dividend Discount Model	Using CAPM and Reuters	Using CAPM and CAGR
Current Share Price	$59.34	$61.93
Current Market Cap at Estimated Price	$203,961,911,603.38	$212,844,085,965.03

As seen above, we used both our calculated dividend growth rate (using the CAGR) as well as the growth rate provided by Reuters.com. Our share price calculations indicate that the company’s current stock price understates the intrinsic value of the company and further, that the stock is priced incorrectly. Given the future growth expectations of the company along with its continually strong annual financial statements and absent any near-term market freefalls (as seen during the mortgage crisis), we expect J.P. Morgan’s fair value to maintain and expand its strength.

We again used the DDM in order to forecast the future values of J.P. Morgan’s future expected price using our calculated growth rate of 1.82% as well as Reuters growth rate of 1.71%. Therefore, the below listed dividends and market capitalizations were obtained for the next five years:

Expected Dividend/Share Price/Market Cap.
Based on Reuters Expectations	2009	2010	2011	2012	2013
Expected Dividend	$1.55	$1.57	$1.60	$1.63	$1.65
Reuters Estimated 5-yr Growth Rate	1.71%	1.71%	1.71%	1.71%	1.71%
Expected Price	$60.36	$61.39	$62.44	$63.51	$64.59
Expected Market Cap*	$207.45	$211.00	$214.61	$218.27	$222.01
Based on CAGR Calculations	2009	2010	2011	2012	2013
Expected Dividend	$1.55	$1.58	$1.60	$1.63	$1.66
Calculated 5-yr Growth Rate	1.82%	1.82%	1.82%	1.82%	1.82%
Expected Price	$63.05	$64.20	$65.36	$66.55	$67.76
Expected Market Cap*	$216.71	$220.65	$224.66	$228.74	$232.90

* Market Capitalizations are in billions

Additionally, a sensitivity analysis was performed comparing different growth rates with various required returns. Based on this analysis and assuming both the dividend growth rates and required returns remain near their historic averages, we expect the intrinsic share price value to be within a range of $45-$101.

	Dividend Growth
Required Rate of Return	1.6%	1.8%	2.0%
3.5%	$80.00	$89.41	$101.33
4.0%	$63.33	$69.09	$76.00
4.5%	$52.41	$56.30	$60.80
5.0%	$44.71	$47.50	$50.67

To add to the validity of our analysis, Reuters calculated J.P. Morgan’s five-year growth rate on dividends to be 1.71%, compared to our 1.82%. These rates are within a close margin of error but it is difficult to compare the two calculations due to the fact that the Reuters website makes no mention of how they derived their results.

Additionally, we used a P/E valuation model to determine the fair market value of the company. Our purpose of using an additional valuation model is to demonstrate that the share prices using both the DDM or P/E valuations models are fairly close.

Year	2008	2009	2010	2011	2012	2013
Expected EPS(1)	$2.40	$3.60	$4.25	$4.75	$5.35	$5.49
Dividend(1)	$1.52	$1.55	$1.59	$1.62	$1.66	$1.69
ROE	6.63%	10.88%	10.88%	10.88%	10.88%	10.88%
Required Return	4.27%	4.27%	4.27%	4.27%	4.27%	4.27%
Retained Ratio	33.00%	49.00%	61.00%	61.00%	61.00%	61.00%
Dividend Payout Ratio	67.00%	51.00%	39.00%	39.00%	39.00%	39.00%
Div/Earnings Growth Rate	2.19%	2.19%	2.19%	2.19%	2.19%	2.19%
Estimated Fair Price	$72.90	$74.49	$76.12	$77.78	$79.48	$81.22
Estimated P/E Ratio	30.37	20.69	17.91	16.38	14.86	14.79

As can be seen from the table on the previous page, we assumed that the required return would stay constant and that the return on equity will rise to the company’s estimated 10-year average. The expected EPS is based on the estimates provided in the financial analysis section of this paper. The retained ratio estimates were obtained using the values provided by Value Line. We also assumed that J.P. Morgan’s dividend/earnings growth rate will remain stable. Given these assumptions, we believe the company’s fair market stock price should be around $72.90 based on the P/E valuation model. The dividends/earnings growth rate was calculated by multiplying the retained ratio by the ROE. Specifically, given a dividend of $1.52, a required return of 4.27% based on the CAPM, and a dividend/earnings growth rate of 2.19%, dividing the dividend by the difference between the required return and the growth rate provides the $72.19 per share price of the stock.

Additionally, a sensitivity analysis was performed as follows:

	Required Return
	3.00%	3.50%	4.00%	4.50%	5.00%	5.50%	6.00%	6.50%
Retained Ratio = 30%	$150.12	$100.50	$75.53	$60.50	$50.46	$43.27	$37.88	$33.68
35%	$223.12	$128.68	$90.41	$69.68	$56.69	$47.78	$41.29	$36.35
40%	$434.29	$178.82	$112.59	$82.16	$64.68	$53.33	$45.37	$39.48
45%	$8,106.67	$293.01	$149.20	$100.08	$75.29	$60.35	$50.35	$43.20
50%		$810.67	$221.09	$128.00	$90.07	$69.49	$56.56	$47.69
55%			$426.67	$177.52	$112.07	$81.89	$64.51	$53.22
60%			$6,080.00	$289.52	$148.29	$99.67	$75.06	$60.20
65%				$784.52	$219.10	$127.33	$89.74	$69.29
70%					$419.31	$176.23	$111.56	$81.61

Interpreting this information requires acceptance of the assumption that the company’s ROE is around 6.63%, the dividend/earnings growth rate is 2.19%, and the 2008 dividend will be $1.52. Factors that can have a strong impact on the validity of this analysis would be changes in the company’s beta, the risk-free rate, and the expected return on the market. Slight changes in those values would have a large impact upon the price of J.P. Morgan’s stock.

Morningstar’s valuation as of August 14, 2008 provided an estimated fair market value of $60 per share. Although they derived this number using a 7 percent cost of equity and 5 percent growth rate, I believe their numbers differ from our calculations due to our use of the CAPM model and more current rates for the risk free and market returns. In any case, the difference between our estimated cost of capital and growth rate (r – g) versus Morningstar’s cost of capital and growth rate (r – g) is fairly similar.

BULLS VS. BEARS

This is a historic time for the economy – specifically in the financial markets – for the financial industry. In fact, much of the credit crisis is the result of problems that arose within the financial industry and it has had an enormous economic impact on the overall economy. Given the current economic situation, our analysis of J.P. Morgan’s (JPM) industry, our analysis of their financial health and profitability, and our stock valuation of the company, we have provided the following arguments for bulls and bears. It should be noted that JPM’s current market price was approximately $48 at the time of this analysis, and we estimated their fair market value to be in realm of $60-70 per share as illustrated in stock valuation section.

Bulls

· JPM’s financial health & profitability is superior to the industry average as well as its primary competitors (reference to financial analysis section). JPM’s strong capital position, even after the acquisition of Bear Stearns, remains in good position to purchase another beaten-down institution at an attractive price. This would further increase JPM’s intrinsic value, and ultimately lead to higher earnings and share value in the future.

· JPM is a well-diversified financial institution, and has become even more so since acquiring Bank One and Bear Stearns. We believe that given its reputable status around the globe that JPM will be better equipped to handle an economic slowdown and ultimately rebound with higher earnings and share value.

· We have estimated JPM’s fair value to be between $60-70 per share. Given our fair value assessment of JPM, even at a discount, it is higher than its current market price of approximately $48 at the time of this analysis.

Bears

· JPM’s financial health and profitability has been superior to the industry; however, a noteworthy portion is derived from the value of its derivative book. As of the 2nd quarter 2008, JPM has $77 trillion in exposure to derivative contracts. Even though much of this exposure is offsetting, it is difficult to accurately assess the true underlying risk from this exposure.

· The current economic slowdown could cause JPM to sustain loan losses greater than expected. JPM has strong financial health and profitability; however, even banks with these qualities could struggle in a prolonged economic downturn.

· J.P. Morgan seems to have a healthy relationship with the government as is evident in the way the government has aided the company in their acquisition of Bear Stearns. We believe that if the company were ever to succumb to the pressures associated with the current economic downturn, the government would be willing to back them up.

RISK

J.P. Morgan’s risk assessment takes into consideration an extremely volatile economic environment in an industry that is at the forefront of this crisis. These unprecedented events include the demise of investment banking industry, the subprime lending sector, and a credit crunch that is threatening the lending industry at its core and pushing the global economy towards a deep recession. Some of the biggest and most prestigious companies on Wall Street like Merrill Lynch, Bear Stearns, Lehman Brothers, Countrywide, and AIG have disappeared or are ceasing to exist. The banking industry has been considerably impacted by a historic number of bank failures and witnessed the biggest bank failure in its history as Washington Mutual declared bankruptcy on September 26, 2008, and was absorbed by J.P. Morgan.

As this crisis has been evolving and deepening it is becoming apparent that there are a few companies that are still standing strong and are actually benefiting from this crisis; these are the companies that had a wider “economic moat” as Warren Buffett coined the term. Economic moat is a reference to the competitive advantage that companies have over other companies in their industry. Companies with a wider moat have a larger and more sustainable competitive advantage and they achieve that through a well-known brand, large section of market demand, pricing power and financial strength. These companies act as barriers by not allowing competitors to enter their industry. Even though the banking industry is experiencing an overall consolidation, J.P. Morgan can without a doubt be described as having a strong “economic moat.”

J.P. Morgan could certainly be negatively impacted by the systemic risks of the industry as this crisis moves further into uncharted waters and the economic headwinds push the economy towards recession. We believe that many of its segments such as card services and retail financial services will experience a slow down. Additionally, the exposure of the company to the derivatives markets should not be underestimated as the downfall of Lehman Brothers and Long-Term Capital Management has demonstrated. Since many of these hedging vehicles are intertwined on a global scale many times without clear knowledge of the counterparties involved and their financial stability, there is an inherent systemic risk in these contracts. The fire sale acquisitions of Bear Stearns and Washington Mutual do not seem to impose any increased risk to J.P. Morgan since the government provided protection guarantees for Bear Stearns’ assets and the low acquisition price paid for each company.

INVESTING STRATEGY

Short Term Perspective

In the near term, we believe that risk averse investors should view J.P. Morgan’s stock with a hold or avoid strategy in mind. Until the current market dynamics settle and we determine how deep the derivatives market is intertwined with the sub-prime mortgage fallout, it would be best to hold and/or wait until the market becomes less volatile. Given J.P. Morgan’s current financial status, we do not believe this company will experience anything to the magnitude of the problems seen at Lehman Brothers, Washington Mutual, or AIG.

For the more risk tolerant investor looking to invest in some of the more stable financial companies, we believe J.P. Morgan would be a good buy at this time. According to our analysis, the stock is undervalued by 19-34% and most investors would consider this a good buy. However, just because a stock is undervalued does not mean that one should invest and expect positive returns. Despite J.P. Morgan’s relative financial strength, if the market believes they are not strong enough, their price could continue to suffer losses.

Long Term Perspective

In the long term, we believe this stock to be a strong buy and that it should be a part of most investors’ portfolios. Comparing our analysis and other experts’ opinions with the current market price of the stock, we believe this company is certainly undervalued. Many of the drops this stock has experienced in the past year are not the result of company specific news, but rather, industry and sector woes. This has unfairly caused J.P. Morgan’s price to decline while its financial statements remain fairly strong in comparison to their competition.

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