We believe that narrow-moat Morgan Stanley may be underselling its likely expense and revenue synergies in its announced merger with narrow-moat E-Trade. The all-stock deal (where E-Trade shareholders will receive 1.0432 shares of Morgan Stanley for each share held) values E-Trade at about $13 billion. We are placing our fair value estimate for E-Trade under review, as we're likely to raise our fair value estimate for the company around 15% based on an estimated 75% to 100% probability that the deal is completed. We don't at this time anticipate a material change in our fair value estimate for Morgan Stanley, as any value added from the $13 billion acquisition isn't likely to be that significant compared with our $90 billion valuation for the firm.
Morgan Stanley laid out $550 million of synergies from the merger--$400 million coming from general administrative expenses (about 25% of E-Trade's 2019 expense base) and $150 million from funding synergies--but these numbers look conservative to us. In the Charles Schwab-TD Ameritrade deal, Schwab is aiming for expense synergies equal to 60% to 65% of TD Ameritrade's expense base. While the business models at Schwab and Ameritrade are more similar to each other than they are at Morgan Stanley and E-Trade, we expect that more expense synergies could be realized as Morgan Stanley has more time to look at E-Trade's operations. A big piece missing in Morgan Stanley's synergy targets is revenue, which would provide upside.
We see two implications from this deal on wide-moat Charles Schwab and narrow-moat TD Ameritrade. The first is negative in that it takes away a merger with E-Trade as a backup plan for Schwab if its merger with Ameritrade falls through because of overconcentration in Registered Investment Advisor market share. The second is positive in that it provides an example for regulators that the investment-services industry is competitive and lines between business models are blurring.
E-Trade's business model is based on operating a fixed-cost platform to attract retail traders and stock plan participants. While it is known for its trading platform, E-Trade's recent decision to eliminate most of its trading commission fees highlights that its business model is based more on interest income than on fee income. E-Trade derives net interest income from transferring the excess cash in client accounts to its bank to buy primarily high-credit-quality, agency mortgage-backed securities. Overall, E-Trade is a highly scalable business that is leveraged to interest rates and the overall market.
As an online brokerage, E-Trade is quite scalable because it does not face the brick-and-mortar fixed costs of many traditional banks and avoids the higher interest expenses of many digital-native banks. The net result is high incremental operating margins on new revenue and high operating leverage. We expect that E-Trade's scalability will allow the company to expand its operating margin with revenue growth over the next 10 years.
E-Trade is leveraged to the overall market because clients leave a reasonably consistent amount of cash in their portfolios, so the level of deposits that can fund interest-earning assets is somewhat determined by the market. E-Trade is leveraged to the interest-rate environment because prevailing interest rates determine the rate at which the company can invest in mortgage-backed securities. E-Trade has a laddered bond portfolio, so it locks in current rates for several years.
E-Trade has announced a plan to almost double earnings per share and meaningfully increase profitability while delivering most of its earnings per share back to shareholders over the next five years. Since E-Trade is operationally leveraged to the capital markets, we view this plan as feasible only under the most benign capital market environments. While we are skeptical that E-Trade will be able to deliver results to the extent it claims, we think the company is committed to increasing profitability and delivering returns to shareholders, which we are positive on.
Although E-Trade destroyed a substantial amount of shareholder value during the financial crisis, the company has structurally changed its business for the benefit of shareholders. E-Trade now warrants a narrow moat rating based on cost advantages driven by switching costs from its deposit franchise and scalable business model. The deposit franchise is advantaged because transactional deposits from brokerage-client cash and employee stock plan deposits receive less pricing pressure than traditional bank deposits. E-Trade's business mix is heavily skewed toward active retail traders, which tends to be a more productive clientele. E-Trade's business model is highly scalable because it does not rely on traditional brick-and-mortar infrastructure to generate deposits.
We believe that E-Trade's cost of funding advantages and operational scalability grant it sustainable economic advantages that warrant a narrow moat based on cost advantages and switching costs. First, we are confident that E-Trade will be able to exert pricing power over its deposit base over the foreseeable future. Second, we think that E-Trade's business mix is advantaged, which allows the company to more easily spread the fixed costs of running a brokerage business across a smaller base of client assets. Finally, we think that E-Trade's highly scalable business model will work to its advantage in the coming years, as we expect that secular growth will allow the company to become more efficient.
E-Trade, as a brokerage, does not face the same deposit pricing pressures that other deposit-taking operations face. Qualitatively, this is because much of E-Trade's deposits are the cash balances in investment accounts that are waiting to be traded. The primary purpose of this cash is to take advantage of a perceived market opportunity, so the value that E-Trade brings to the relationship with the customer is the best execution of trading and an easy-to-use investing platform. Further, the cash balance is a relatively small amount of investment account value, generally about 13% of a customer's account, so marginal changes in deposit costs would have less than a 1:1 impact in changes in account return. Since cash yield is not the primary focus for traders, discount brokerage firms have largely been able to slow the rate of deposit cost increases despite rising interest rates, unlike many other deposit-taking institutions.
Quantitatively, this deposit cost advantage dynamic can be seen over the past interest rate cycle by examining the relative costs of funding. Publicly traded discount brokerages have had low costs of funding relative to the banks under our coverage over this interest rate cycle. E-Trade has had particularly low costs relative to peers in recent years, and we do not see this advantage deteriorating over the foreseeable future. We envision a future in which E-Trade continues to focus on scaling up its brokerage because there are strong secular tailwinds driving assets to lower-cost retail brokerages and E-Trade. Despite its relatively small scale to other publicly traded online brokerages, the company has been able to outpace the industry's client asset growth. Fundamentally, low-cost investment options have a long growth runway, and E-Trade is reasonably well positioned to benefit from this secular trend.
Although we recognize that E-Trade is opening a series of higher-yielding savings accounts, which partially drove rising interest expense last year, we do not believe that a small segment of higher-yielding liabilities will materially detract from the funding cost advantage. Fundamentally, we think that customers come to E-Trade because they want to use its brokerage services, not its savings account services. We agree with management that the primary use case for these higher-yielding savings accounts is for customers who do not want to be in the market for an extended period. We do not anticipate that E-Trade's customers will be able to arbitrage the relationship by constantly moving brokerage cash into and out of the savings accounts due to regulations such as CFR Title 12 Regulation D, which limits the number of monthly withdrawals from a savings account. Further, a trader could not arbitrage the relationship by moving the funds to a higher-yielding bank. If the investor moves the cash out of E-Trade's platform, they lose the ability to trade rapidly as ACH interbank transfers take several days to complete and bank wires can get prohibitively expensive.
E-Trade's focus on active retail traders and stock plan participants enhances its cost advantages. Active retail traders are some of the most productive clients for discount brokerages, which reduces the scale necessary to achieve profitability. Active traders are more productive clients because they hold higher proportions of cash and thus higher deposit balances in their accounts. We believe that active traders hold higher cash balances so they can make larger bets on perceived market opportunities and because they do not have an advisor to periodically reinvest for them. Active trader clients are also more productive because they take greater advantage of the brokerage's margin capabilities and trade more frequently. That said, these revenue sources are nowhere near as important to E-Trade as the client cash. We think E-Trade's hold over the active trader client base is sustainable because client retention is high and because E-Trade continues to invest substantially in marketing that directly targets these traders.
We also like E-Trade's stock plan administration business as a source of new deposits. E-Trade administrates employee stock plans for nearly 800 U.S. publicly traded companies, with a focus on technology firms. E-Trade monetizes stock plan participants by investing the float after participants sell and by converting participants into ordinary brokerage account holders. E-Trade has been reasonably effective in converting stock plan participants into regular brokerage clients, which we think is indicative of switching costs. About 35% of E-Trade's total deposits were originally sourced through employee stock-purchase plans, and E-Trade retains about 15% the employee stock sales value in cash 12 months after the sale. Though employees can move their assets to other banks and brokerages after the sale, many choose not to. This is a sustainable growth runway because employees are required to use the employers' choice of stock plan administration, and the contracts are frequently multi-year. Higher cash balances can directly be tied to higher revenue per dollar of client assets because it provides more deposits that can be put into interest-earning assets.
We think that E-Trade has gained the scale necessary to earn a moat in a highly scalable, fixed-cost business. Discount brokerages do not need much additional physical or technological capital with additional client assets on their platforms. The primary expense that scales with revenue is interest expense, so operating leverage on each additional dollar of revenue is quite high. The scalability of the business model can be seen quantitatively through the ratio of noninterest expense over client assets. Although E-Trade has by far the smallest scale of any of the online brokerages and the highest noninterest expense over client assets, it has made substantial gains and additional scale will only benefit the company.
Our fair value estimate for E-Trade is $46.50 per share, which implies a 2020 price/earnings ratio of 13.1 times and a price/book ratio of 1.8 times. We assume a dynamic capital markets environment in our base case, with a bear market and a series of federal funds rate cuts to 1.5%. We anticipate there is a lot of upside and downside in the stock depending on how the yield curve develops, which determines the rate at which E-Trade can invest, and how the market performs, which determines the level of deposits that can fund investment securities.
E-Trade's revenue growth strategy is based on generating more client cash to fund net interest income growth or to earn more fee income by depositing the client cash in a third-party bank. Recently, over 60% of the company's net revenue was composed of net interest income. We think E-Trade's balance sheet has a substantial growth runway given its relatively low market share and strength in the stock plan business. We expect that E-Trade will be able to increase deposits at a 6.4% compound annual growth rate (CAGR) over the next 10 years.
We expect that E-Trade's net interest margin will decline in the first five years of our model due to rate cuts. This results in a net interest margin that varies between about 2.4% and 3.2% over the next 10 years, with margins normalizing at the higher end of that range as rates normalize. We expect that E-Trade will be able to increase the sum of on-balance sheet net interest income and off-balance sheet interest income at a 6.5% CAGR over the next 10 years.
We are less optimistic about noninterest income. A little over half of E-Trade's trailing noninterest income comes from trading commissions, which is declining precipitously as E-Trade has matched competitors' commission fee cuts. The other major contributor to noninterest income is payment for order flow, which we expect to increase as E-Trade gains more scale and thus more orders. We expect that E-Trade's decision to reduce commission fees will more than offset modest noncommission revenue growth, leading to a noninterest income CAGR of negative 1% over the next 10 years.
Overall, we anticipate that E-Trade's balance sheet strategy should allow it to deliver substantial gains in profitability. We expect that E-Trade's return on equity will normalize 16.5% and that both net income growth and repurchases will allow the company to achieve double-digit growth in diluted EPS in the later years of our forecast.
The two biggest risks to E-Trade are interest rates and the market. Most of E-Trade's assets are agency mortgage-backed securities, so the prevailing interest rate determines the yield at which E-Trade can reinvest. We think that E-Trade's deposit base is quite low cost, so it would be difficult for E-Trade to reduce deposit yields faster than asset yields in a downward interest rate shock.
The second big uncertainty is market returns. E-Trade's customers consistently leave about 10%-20% of their total asset base in cash, which E-Trade then uses as deposits. If market fluctuations decrease the aggregate value of customer investments, then E-Trade's deposit base would shrink as well. A shrinking deposit base inherently limits E-Trade's supply of low-cost funding, which would limit E-Trade's investment security purchases.
Another uncertainty in E-Trade's future is its aggressive growth and shareholder payout program. E-Trade intends to materially grow its balance sheet to collect additional interest income over the next five years while simultaneously delivering about 80% of its earnings back to shareholders, instead of keeping the earnings on the balance sheet as excess capital. E-Trade's target Tier 1 equity ratio is reasonably close to the regulatory "well-capitalized" minimum, 6.5% versus 5%, so E-Trade's aggressive growth and capital return program does not leave much room for error.
Since a large portion of cash flow is highly variable and dependent on market-related factors that are inherently unknowable, we award E-Trade a very high uncertainty rating.
We rate E-Trade's equity stewardship as Standard.
E-Trade destroyed a substantial amount of shareholder value during the financial crisis. E-Trade's business model before the crisis involved using deposits to purchase mortgage-backed securities with credit risk and mortgages wholesale from third parties. As E-Trade was highly exposed to the wrong market at the wrong time and did not have a relationship with many of its lendees, the results were devastating. The company needed to raise capital several times and received funding from hedge funds to survive. E-Trade's executive chairman, Roger Lawson, has compared this company's experience since the financial crisis to Lazarus rising from the dead, and frankly, we don't think this biblical comparison is excessive.
Today, E-Trade has a structurally different business model. It does not take on credit risk because many of the securities it purchases are implicitly backed by the government. There is a still a legacy loan book, but it is now immaterial relative to the size of the balance sheet and E-Trade intends to run off the remaining portfolio. We think that this shift makes sense given E-Trade's troubled history with credit risk.
In mid-August 2019, E-Trade announced that COO Michael Pizzi would succeed Karl Roesner as CEO effective immediately. Pizzi is an insider who has been with the company since 2003 and has served as chief operating officer, chief financial officer, and chief risk officer during his time with the company. We think that an insider who has seen how close the company came to failure is likely to be more cautious about risk. We are looking forward to examining the extent to which Pizzi keeps the shareholder in mind during his tenure, as we think that the company prioritized shareholder remuneration through share buybacks and instituting a dividend under previous management.
