NEW YORK (MONEY Magazine) - Riding the online trading boom in the late 1990s, Charles Schwab grew so big that its market capitalization briefly vaulted ahead of Merrill Lynch's. Schwab's model -- offering inexpensive transactions to the masses -- seemed triumphant.

Then the bubble burst.

Anything you might say about how bad the past three years have been for retail investors won't be harsh enough to capture how rough things have been for Schwab.

Revenue in the latest 12 months has fallen 32 percent from the pinnacle in 2000, and profit has tumbled 84 percent. Meanwhile, investors whacked some $50 billion off Schwab's market cap.

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Schwab responded by slashing costs and accelerating its plan to become less dependent on the volatile (but extremely lucrative) trading business, and to increase its reliance on the more stable (but lower-margin) asset management business.

In effect, it is adopting the big Wall Street brokerages model that once seemed so passe. "They want to be wealth gatherers, rather than simply getting $36 each trade," said Anna Dopkin, manager of T. Rowe Price Growth & Income fund, a Schwab shareholder. "That is what every firm wants."

Indeed, Schwab began transforming itself even before the market crash. Its first big move was the purchase of white-shoe U.S. Trust (which manages money for millionaires) at the peak of the bull market in 2000.

Since then, it's added its own private-banking business, for those with $500,000 or more, and launched a slew of one-off advisory deals for customers who want help managing their money -- seemingly everyone these days.

This winter, for example, Schwab (SCH: Research, Estimates) promoted a one-time portfolio checkup (give us your assets, we'll help you rebalance) for $95, instead of the regular price of $250-to-$1,000, and brought in $4 billion in assets.

More recently, it's moved in on the refinancing boom, cross-selling mortgages to clients through its new bank. And it has begun offering advice to 401(k) participants as well.

Still, Schwab is determined not to become just another Wall Street brokerage house. So while it is rating stocks (using a quantitative system that grades them from A to F), it will not hire research analysts. And it will not launch an investment banking business. It was the interplay of these two that led to Wall Street's conflict-of-interest scandals.

David Pottruck, Schwab's blunt-talking chief executive, bristles at the perception that Schwab is merely a discount brokerage or an online trading firm. "When we think of who we are, we think of ourselves as offering the choice of everything from discount to full service," Pottruck explained during a meeting at MONEY's offices. "We are a full-service firm without the conflict."

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Like every other brokerage, Schwab is trying to wring more money out of each additional dollar of assets. It has, for example, increased fees to investors who either don't keep $50,000 in their accounts or don't make at least eight trades a year.

Largely as a result of those new inactivity fees, Schwab closed more accounts than it opened in nine of the past 10 months. "It's now focused on the profitability of accounts instead of the number of accounts," said Jeffery Harte, an analyst at Sandler O'Neill.

Schwab's changing business mix can be seen in the numbers. In 2000, trading commissions accounted for 39 percent of revenue, while asset management and administration made up 27 percent; for the latest 12 months, those numbers are flipped, with trading accounting for 29 percent of a shrunken total, and asset management and administration for 44 percent.

While trading commissions should rebound once individual investors return to the market, Schwab spokesman Glen Mathison notes that "we have for some time been shooting for a more even balance."

One key to the success of that strategy will be how good a job Schwab does of gathering assets. So far, the signs are encouraging.

Over the past four quarters, it added $41 billion in net cash from clients (it now manages a total of $845 billion). But Schwab hasn't turned the corner yet: In the latest quarter, net asset inflows were weak -- just $6.5 billion versus $11.5 billion in the same period the previous year -- despite a bull run for stocks.

July saw the pace pick up again, with $3.9 billion coming in. This remains a key number to watch in the future.

"The leverage is dramatic," said Jim Oelschlager, manager ofWhite Oak Growth Stock fund, a Schwab shareholder. "You build this base of assets that are all set to appreciate."

The challenge for Schwab will be to keep its distinctive character and its popularity with do-it-yourself investors even as it looks more and more like a conventional brokerage.

That may not be easy. Schwab's integration of U.S. Trust has gone slowly because of cultural differences. And there will be risks in managing all of the various advisory businesses -- including the independent financial advisers on whom Schwab has long relied -- so that they don't cannibalize one another.

Schwab still needs to court well-off investors who have less than half a million dollars to play with. They are, after all, the vast majority of investors and Schwab's core market.

"The question is: What can we do for less money? What can we do for the man who has $200,000?" Pottruck asked. "We're working on that."

If Schwab can solve that puzzle, it may yet be able to play the asset game without losing the uniqueness of its franchise.

Schwab remains one of the great finance companies. It has a recognizable brand, a formidable asset base, and the ability, proved several times since its founding in 1973, to adapt to new investing climates.

The company's business model is also enviable. As the market rebounds and Schwab's assets under management rise, fee revenue should increase and trading commissions bounce back, boosting profits without much effort.

Morty Schaja, president of Baron Funds, one of Schwab's biggest boosters and the owner of 14 million shares, figures if the market rises 7 percent-to-10 percent a year and Schwab adds 5 percent-to-10 percent a year in new assets, it could double assets in five years, tripling revenue and increasing earnings exponentially.

But at a recent $13, Schwab trades at a dear 39 times the 2003 estimate of 34 cents a share, and even on 2004 estimates, its price/earnings ratio remains pretty steep at 30.

Sure, that's down from the once-gaudy P/E ratio of 150, but it's still a huge premium to that of its brokerage peers.

Sanford Bernstein's Brad Hintz argued that such a valuation flies in the face of "moderating growth expectations for the firm, disappointing new account openings and weak asset inflows."

But perhaps the biggest reason to temper our enthusiasm: The stock is up more than 80 percent since March's trough. "They are strategically doing the right things, but the valuation is hard to justify," said Jeffery Harte of Sandler O'Neill.

He thinks the stock should be trading at $8.50.