Bank of America (BAC) shares have more than doubled off of their 2012 lows on the back of greatly improving fundamentals, overall market bullishness, and perceived imminent capital distributions, with a little help from the Federal Reserve. The massive profits haven't shown up yet but most investors, including me, think that the profits are on the way in 2013 and beyond.
One metric that doesn't get a lot of press is Economic Value Added. If you are unfamiliar with the concept, the link provides a stellar primer on the concept and the copious amount of data that is needed to calculate it over a period of time. Basically, the idea of EVA is that a company should earn more than its economic cost of capital on its asset base. If the company doesn't do this, EVA is negative. The measure isn't meant for banks necessarily because the asset base gets skewed by the mere fact that it's a bank, but applying this measure to Bank of America over the past 8 years of operating results yields some interesting findings.
In order to compute these data and provide the graphs below, I pulled all the components of EVA, which you can review from the article linked above, from Bank of America's Qs and Ks. All pieces of EVA are pulled from financials except for equity risk premium rate, which is used in calculating the company's weighted average cost of capital. For this exercise, I used 9% as the equity risk premium for all periods.
The first graph we have is that of average total assets and annual EVA plotted against each other.
As you can see, Bank of America's average assets (blue line, left scale) trended up at a very rapid pace in the years leading up to the financial crisis. A larger asset base, all other things equal, is great for a bank as it can charge interest on those assets when they are loaned out.
Next, the TTM EVA (red line, right scale) shows that BAC's EVA has been negative since at least the end of 2004. That is not what is necessarily as important here; rather, focus on the extremely negative slope of the EVA line in comparison to the total asset base. It stands to reason that as total assets rise, BAC must continue to earn the same EVA percentage on its new assets as the existing assets or its number will decrease. However, the pace with which BAC was decreasing EVA is astonishing, with the number dropping from about -$20 billion in 2004 to a whopping -$120 billion in 2011. The number has since rebounded to about -$85 billion but we are still a long way from zero or even -$20 billion for that matter.
Seen another way, this graph shows EVA as a percentage of average assets. Essentially, this is the same data but plotted in a different way to make it a bit easier to understand.
Again, we see that EVA has been negative for the time period I pulled the data for but the trend is the same. We see a very steep decline in EVA as a percentage of total assets until 2009 when it bottoms and then rises last year to about -4%.
Given this information, we can extrapolate how much profit BAC is leaving on the table currently, given its historical EVA margins. We can then figure out what it means for BAC's valuation and potential profits in the future.
BAC currently has total assets of about $2.150 trillion. We can see that BAC has historically earned up to -2% EVA during the data set that I pulled. If BAC can return to earning -3% EVA, that could mean an additional $21.5 billion in after-tax income available to shareholders. If BAC could return to -2% EVA, an additional $43 billion of net income would be the result. The point is, for every 100 bps of additional EVA margin, BAC's asset base would produce an additional $21.5 billion in net income. Before you laugh, keep in mind the company has already improved its EVA margin by 140 bps from the low in 2011 to the end of last year. If BAC can improve another 140 bps, that could mean $30 billion in additional net income.
I think these estimates are realistic and representative of what BAC can do in the future because of a few reasons. First, debt is very cheap. Bank of America is reporting roughly $18 billion per year in interest expense versus over $50 billion annually pre-crisis. In addition, we can see that BAC's asset base has doubled since that time. This means that a more comparable pre-crisis number would be something like $100 billion in annual interest expense for BAC's current asset base. The point is BAC is financing its asset base very, very cheaply. This is unlikely to change within the next couple of years given the Federal Reserve's QE Infinity efforts.
Second, BAC has done a phenomenal job of reducing risk in its asset base by improving credit quality and divesting non-core businesses. This is obviously paying off as EVA margin is back above -4% for the first time since 2007 and the slope of the line is very steep. As BAC continues to divest non-core and underperforming assets, the asset base will grow smaller and EVA margin will increase, boosting net income. As long as EVA margin grows more quickly than the asset base declines, it will be accretive to shareholders.
Third, the economy has improved vastly in the past three years and in particular, this strength can be seen in the housing market. Bank of America is a huge player in the mortgage market through its Countrywide acquisition and the strength in this area of the economy will have a disproportionately positive effect on BAC, given that the strength continues.
BAC has had a very tough time in recent years producing economic value from its asset base. However, the economic and fundamental pieces are in place for a huge rebound in net income. In addition, the EVA margin graph I presented above shows that this rebound is in full effect and showing no signs of stopping. If BAC can get back to -3% EVA or even -2%, tens of billions of dollars of additional net income will be available to shareholders and the share price will move higher to reflect this.