Bank of America (NYSE:BAC) posted reasonably good results, given the downturn that the U.S. economy has taken recently. I believe that now is a good time to buy BAC stock while some uncertainty still lurks about its future.
Everyone knows the banks took a hit in Q1. Bank of America’s diluted earnings per share fell 43% from 70 cents to just 40 cents. But one measure of Bank of America’s profitability is still impressive.
Bank of America’s Impressive Return on Capital
The bank’s average return on allocated capital was still 19%, according to its news release. Granted, this was down from 34% last year, but making 19% on capital is still very respectable. By the way, I assume this was an annualized measure for Q1.
Here is why that matters. If you make 19% on your total capital (debt plus equity) over four years, your capital will double in size. So that is a very good result for most investors. This is especially true for large money-center banks like Bank of America.
Bank of America has $241.5 billion in equity capital. Even with the write-offs and loan losses, the bank made $4 billion in profits in Q1, down from $7 billion a year ago.
That implies that Bank of America’s return on equity capital of $241.5 billion was 6.6%. This is derived by annualizing $4 billion in earnings ($16 billion) and dividing this by $241.5 billion in equity.
This is still a very good return. For one, it is better than a loss or reduction in equity capital. Second, compounded over five years, assuming nothing changes, Bank of America’s book value would grow by 37.8% over the period.
That is still a very good return for investors.
Why Bank of America’s Book Value Will Likely Grow
Banks have strict rules about when they have to start writing off loans. Bank of America took a huge “bathroom sink” reserve of $3.7 billion for future loan losses. What this means is it voluntarily reduced book value by $3.7 billion. The bank expects that this will be the result of loans going bad from the ramifications of the novel coronavirus.
This implies that quarterly earnings over the next year or will be substantially higher than the $4 billion in Q1. This project that the company will likely make closer to $20 to $24 billion in net income over the next year.
This will be the result from ever-higher economic activity taking root. Keep in mind that the Bank has already estimated how many loans will go bad over that period.
Therefore, the estimated return on equity over the next year is likely to be closer to 10%. If a bank grows its book value on a compound basis of 10% over three years, it will grow by one-third (33.1%).
BAC Stock Is Too Cheap Selling Below Book Value
At this writing, Bank of America’s market cap is $200.2 billion. But its common stock book value is $241.5 billion, or $27.84 per share. So, BAC stock trades for just 82.8% of book value. I suspect that is too cheap.
Here is why. If book value grows by 10% on a compounded basis over three years, it will rise by one third. That takes it to $37.06 per share. If BAC stays at $22.93 over the next three years, it would trade for just 61.9% of its book value. That is just too cheap. The stock is likely to rise to over book value per share.
Usually, a stock trades for less than 80% of its book value if it is losing money. Investors assume that the losses will reduce the book value. But Bank of America is profitable and will likely make up to 10% return on equity each of the next three years. Therefore, the stock will likely return to a premium of at least a third over book value per share.
In addition, the Bank pays a dividend that yields over 3.1%. We can add that into the expected returns for BAC stock.
The Expected Return for Value Investors
For example, let’s assume that the stock trades for 1.3 times book value by the end of three years. That would take the stock back up to $48.18 per share (i.e. 1.3 times $37.06).
That represents a return of 210% over the next three years. On a compounded basis, that is a 28% per average ROI. If you add in an average 3% dividend yield each year, the total return one can expect is 31% per year.
This is why Bank of America is a very good investment right now, especially for value investors who like to buy stocks below book value.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide, which you can review here.
