Ally Financial stock (NYSE:ALLY)

Ally stock (NYSE:ALLY) suffers as credit conditions in the automotive market deteriorate, and interest rates rise. The auto lender’s stock was down 43% this year as of Wednesday’s close, more than doubling the S&P 500’s nearly 20% drop.

Even with the short-term earnings pressure, now could be a good time to buy Ally Financial stock if you have a long time horizon. This is why.

The Good and the Bad in Third-Quarter Earnings

Ally’s third-quarter earnings, which were announced earlier this month, were, at best, below average. The company’s net income in the quarter was $272 million, down from $683 million in the same quarter last year. Why did earnings fall so sharply? There is one primary reason.

With the Federal Reserve raising interest rates sharply, Ally has increased the rate it pays depositors to keep money in the bank. Ally makes money by lending these deposits for car loans and other lending products, which typically have a fixed rate for a set period of time. As a result, when it is forced to raise the interest rate, it charges consumers, and the spread between the interest it pays and the interest it receives narrows. This is known as the net interest margin (NIM). Management expects NIM to fall to 3.5% in the coming quarters. This will have an impact on earnings until its auto loan book is repriced to higher interest rates, which will widen the spread again.

Ally’s consumer banking division is critical because it provides the company with low-cost deposits to fund its lending operations. With consumer deposits steadily rising, there’s no reason to believe Ally’s earnings won’t resume their upward trend once interest rates and used car prices have stabilized.

Consider the Big Picture

If you own Ally Financial stock (NYSE:ALLY), you have every right to be concerned about what might happen to its earnings in the coming quarters. But, in the long run, the company appears poised to succeed and return significant value to shareholders at these prices.

With a market cap of around $8 billion, Ally is currently trading for less than its book value, an important metric for a bank stock. Due to its low-cost deposits and zero-branch model, management believes it can return 16% to 18% annually on this book value over the long term, which could result in investors earning more than that each year if shares are purchased below book value.

However, this return, known as return on equity (ROE), will be lower in the coming quarters. It was only 10% in Q3. This is not a bad ROE, but it is lower than management believes Ally can achieve in a normal macroeconomic environment.

Featured Image-  Unsplash @ PiggyBank

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