Tickers in this Article: SCHW, AMTD, ETFC, TROW, BEN, BLK, IVZ, WDST
It is an unfortunate reality of investing that figuring out whether a company is top-notch is not especially helpful in figuring out whether the stock is a top candidate to buy. True, it often makes sense to own the best businesses that you can find, but the metrics that mark quality and value are not the same.

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In the case of Charles Schwab (Nasdaq:SCHW) it is not hard to argue that this is one of the best brokerage and financial service companies out there. The trick, though, is in figuring out what that quality is worth and the probable path of earnings and cash flow in the coming years. As a growth stock, it looks intriguing, but a return-to-equity valuation shows a different sort of story.

Second Quarter Results Fairly Sound
The second quarter was not all sunshine and bunnies for the stock market, but Schwab did fairly well all the same. Revenue rose 10% from the prior year, while falling about 1% from the prior quarter. Although commissions were lower (about 15% lower on a sequential comparison), net interest revenue was modestly higher and client assets did tick up 1% as the attrition rate fell.

Schwab did even better controlling its expenses. Core operating expenses rose 7% on an annual comparison and fell 2% sequentially, and the company saw only a minor deterioration in operating margin on a sequential basis. At the bottom line, reported net income grew 16% and the company produced in-line earnings per share.

Nervous Markets, Nervous Investors
The second quarter of this year was not exactly the calmest stretch in recent experience. Fears of slowing growth in the U.S., a potential debt default and the ongoing trouble in Europe all weighed on the market. That is especially relevant for Schwab because this is a company whose fortunes largely track investor sentiment - when investors feel confident, they invest more and trade more and vice versa when that confidence is shaky. This is by no means unique to Schwab, TD Ameritrade (Nasdaq:AMTD) and E-Trade (Nasdaq:ETFC) experience it as well. At least Schwab has the advantages of a larger retirement business and a sizable institutional services platform.

What Is Growth Going to Look Like?
Schwab shares trade a lot on that aforementioned investor confidence, but those are short-term phenomena. Try trading Schwab, T.Rowe Price (Nasdaq:TROW) or Franklin Resources (NYSE:BEN) on fund inflows and outflows and you'll be trading far too often and experiencing a lot of whipsaw moves.

The bigger issue is where Schwab is going to get that future growth. Higher interest rates will certainly help the company's revenue, but there is ever-present price pressure in the retail business. What's more, the rise of ETFs from the likes of Blackrock (NYSE:BLK), Invesco (NYSE:IVZ) and WisdomTree (Nasdaq:WSDT) is a threat to Schwab's own lucrative mutual fund management business.

Go a step further and think about the investment environment in 10 years' time. Is it not at least a risk that retiring Baby Boomers, particularly those whose home equity was seriously damaged during this recession, will draw down their investment savings at an accelerated rate? Schwab has shown that it can do an admirable job of gathering assets and keeping customers happy enough to stay, but if retirees need to draw out more savings to maintain their lifestyle, that is going to leave this sector scrambling.

The Bottom Line
Long-term investors should be encouraged by the extent to which Schwab works to stay relevant. The company bought OptionsXpress to better position itself in futures and options - where the average trader trades much more often - and the company is expanding its foreign investment options. Likewise, the company has not been remiss in building its institutional business and also looking to compete with its own array of proprietary ETFs.

Valuation is the tricky part here. Schwab is certainly growing, but it's not a growth stock like WisdomTree and it seems odd to value it like one. On the other hand, a straight forward return-to-equity model highlights a problem - if Schwab is going to maintain a strong pace of growth, it has to expand that asset base at a healthy clip. While it is true that Schwab's PE is low by historical standards, I would argue that the growth prospects are not as good as they once were and investors should be a little bit cautious about paying a high premium to own a stock in this industry. (For related reading, check out 10 Tips For Choosing An Online Broker.)

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