Mortgage finance companies are a subset of financial services companies (which you can see a separate post of here), but they merit its own mention as the valuation methods have specific nuances.
Before we dive into the valuation of mortgage finance companies, we have to understand how they make money.
How Do Mortgage Finance Companies Make Money?
Let’s look at a real 10K annual report of a mortgage finance company to dissect its revenue streams.
The 3 largest revenue sources are:
- Net Gain on Sales (GoS): the interest rate they charge to their clients on their mortgage loans minus the interest rate they pay to the large banks for the loans. Typically a spread of interest rates that can vary between 1% – 2.5%.
- Loan origination fees: fees charged by the mortgage finance company to the borrower, lender, or both. Typically between 0.5% – 2.0% of the loan amount.
- Loan servicing fees: fees collected by the mortgage finance company to the borrower every time a mortgage payment is made. Typically 0.25% – 0.5% of each payment.
- Note that the loan servicing fees are deducted by a few items to get to net loan servicing fees. These are:
- Change in fair value of mortgage servicing rights and mortgage servicing liabilities: Mortgage servicing rights (MSRs) are contractual agreements that the mortgage finance company enters into lender. The lender gives the right to the MSR holder to conduct all the activities related to servicing the loan, such as collecting payments, paying the insurance and taxes, and sending the funds to the lender. In return, the lender pays the MSR holder a fee for these tasks. MSRs are valued at fair value, which is the price that would be paid in the market if the MSR holder were to sell the contract to another party to resume the servicing activities instead. the change in fair value determines if the MSR rights have increased or decreased compared to the previous period.
- Mortgage servicing rights hedging results
- Change in fair value of excess servicing spread financing
- Note that the loan servicing fees are deducted by a few items to get to net loan servicing fees. These are:
The remaining revenue sources are:
- Fulfillment fees: fees for services related to the acquisition, packaging and sale of mortgage loans.
- Management fees
- Interest income minus interest expense (i.e. Net interest expense, which reduces revenue if interest expense is higher than the interest income)
- Other
Mortgage Finance Companies Valuation Methods
The reason why we focused above on the revenue streams is because the valuation methods of mortgage finance companies that analysts employ involves creating a future P&L projection.
Just as you would with building a DCF model, you have to identify all the revenue streams, expenses, other items that go in the P&L using a bottom-up build approach. This is to get to Net Income or Earnings, so that you can use the Price-to-Earnings ratio to value the company.
That said, the most widely used valuation methods for mortgage finance companies are:
1. Price-to-Earnings (P/E) Ratio
The P/E ratio is a staple for valuing companies across industries, including for mortgage finance company valuations.
After you project the net income for the next 3 to 5 years, you apply the industry average PE ratio to the company’s earnings per share (EPS) to get the projected stock price valuation. If the valuation results in a higher expected stock price relative to today’s price, then today’s price is undervalued.
For example, notable big bank analysts applied 8x to 9x PE Ratio to the 2025 projected earnings or 2026 projected earnings to calculate their base case target stock price.
Based on our analysis of 35 public mortgage finance companies in G7 countries, the median PE ratio as of September 30, 2024 is 8.7x, which is in line with the big bank analysts:
2. Price-to-Book Value (P/BV) Multiple
The P/BV ratio compares a company’s market value to its book value (assets minus liabilities). For mortgage finance companies, this metric provides a snapshot of how investors perceive the company’s equity relative to its tangible assets, including MSRs.
Equity is important, because MSRs are a significant component of book value and equity generates long-term cash flows as borrowers repay loans.
A higher P/BV multiple can indicate robust asset quality or investor confidence in future growth. Notable big bank analysts applied 1.6x to 2.0x as the base case P/BV multiple to the projected future 2025 or 2026 book value to calculate the target stock price.
Based on our analysis of public mortgage finance companies, the median P/BV multiple as of September 30, 2024 is 1.0x, which is in line with the big bank analysts.
3. Discounted Cash Flow (DCF)
For any industry, a DCF method is used to triangulate valuation methods by projecting its future cash flows and discounting them to their present value using a required rate of return.
Due to the predictable income from servicing portfolios, DCF is commonly used to value mortgage finance companies.
4. Gain-on-Sale (GoS) Margin Analysis
As defined above, the GoS margin is a critical metric for assessing the profitability of loan originations. It measures the spread between the cost of originating loans and the price at which they are sold to the borrower.
GoS margins directly reflect a company’s efficiency in originating and selling loans. Higher margins indicate effective cost management and pricing strategies.
While GoS margins are baked into the P&L or DCF projection in the revenue streams, it’s useful to analyze the change in GoS on its own to gather insight on the mortgage finance company’s improving or declining origination efficiency.
Changes in the US Mortgage Industry in 2024
Throughout 2024, mortgage rates remained elevated, with the average 30-year fixed rate reaching approximately 6.9% in November. This increase, coupled with rising housing prices, strained mortgage customers and dampened home sales, leading to the lowest levels since 1995.
The Mortgage Bankers Association (MBA) reported a decline in mortgage originations by about 8% year-over-year, primarily due to reduced refinancing activity as borrowers hesitated to replace existing low-rate mortgages with higher-rate ones.
Despite these challenges, mortgage servicing remained robust. The Office of the Comptroller of the Currency (OCC) noted that 97.4% of first-lien mortgages were current and performing at the end of Q3 2024, a slight improvement from the previous year.
What Can We Expect with Mortgage Valuation in 2025
The Federal Reserve has indicated a potential delay in interest rate cuts into 2025, suggesting that mortgage rates may remain above 6% for much of the year. This persistence could continue to impact borrowing costs and housing affordability.
Potential policy changes, including discussions around the privatization of entities like Fannie Mae and Freddie Mac, could introduce shifts in the mortgage landscape, affecting lending practices and market dynamics.
Analysts anticipate continued consolidation within the mortgage industry as companies seek to scale operations and enhance profitability amid a competitive environment. This trend may lead to mergers and acquisitions among lenders and service providers.
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