Cap­i­tal One Finan­cial (COF) is one of September’s Most Dan­ger­ous Stocks. Free copy of report is here: COF. And like all of our Most Dan­ger­ous Stocks the company has:

1. Mis­lead­ing earn­ings = account­ing prof­its are pos­i­tive and ris­ing while true, eco­nomic prof­its are neg­a­tive and falling
2. High Val­u­a­tion = very high expec­ta­tions embed­ded in the cur­rent valuation.

RED FLAGS:

1. Mis­lead­ing Earn­ings: COF reported a $399mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $1,783mm. The main dri­vers of the dif­fer­ence between Eco­nomic ver­sus Account­ing earn­ings are COF’s (a) nearly $400mm draw-down from its Loan Loss Reserves,  (b) $1,353mm of off-balance sheet debt and © $1,544mm in asset write-offs.
2. The company’s ROIC is in the Bot­tom Quin­tile of all the com­pa­nies we cover.
3. Stock price of $40.69 implies COF must grow its NOPAT at 15% com­pounded annu­ally for 15 years. A 15-year Growth Appre­ci­a­tion Period with 15% com­pound­ing growth rate is quite a high stan­dard to beat, as per my post on How To Make Money Pick­ing Stocks.
   

Over­all, the Risk/Reward of invest­ing in Cap­i­tal One’s stock looks Very Dan­ger­ous to me. There is lots of down­side risk given the Mis­lead­ing Earn­ings and there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

See Appen­dix 4 to learn how COF NOPAT plum­meted even though Net Income rose in its last fis­cal year based on COF’s draw­ing cash out of its loan loss reserve. See Appen­dix 5 for details on COF’s Invested Cap­i­tal. Appen­dix 7 (in the Return on Invested Cap­i­tal sec­tion) shows how the falling NOPAT Mar­gin and flat Invested Cap­i­tal Turns result in a decrease in ROIC (to 1.6% from 6.2%) and Eco­nomic Profit, which fell by $1.8bn while Net Income rose by only $399mm.

As per Invest­ment Strat­egy 101 and How to make money pick­ing stocks, COF fits the pro­file of a great stock to short or sell.

See Finance 101 and Eco­nomic Ver­sus Account­ing Prof­its for more detail on why account­ing prof­its are not reli­able indi­ca­tors of cor­po­rate prof­itabil­ity or value creation.

Note: Stock pick of the week is updated every Tuesday.