The financial sector appears to still be undervalued relative to the S&P 500, despite its massive run-up since the lows of the financial crisis, and I believe Bank of America (BAC) is leading the pack of undervalued U.S. bank stocks.
Forward P/E (1 yr)
Bank of America
Of all the reasons to buy Bank of America, I believe its current valuation falls at the top of the list. It is still trading at just 0.59 times book value, acing the Fed's stress test, which indicates the firm's solvency, and at 9.27 times forward earnings, it is difficult to argue that the company is overpriced. Furthermore, the firm's $5.5 billion share buyback should serve as a catalyst to propel earnings higher and is an excellent indication that the firm's management deems the company's stock to be undervalued. With the average component of the S&P 500 trading at 2.29 times book value, I am willing to take a risk on some of Bank of America's assets being overstated on its balance sheet.
Resurgence of Housing
The housing crisis is all but over and housing continues to go up, with help from dirt cheap interest rates, better than expected employment growth and a short supply of homes on hand. JPMorgan has more than doubled its forecast for U.S. home price gains in 2013 to 7 percent and predicts a more than 14% increase through 2015, and Bank of America is equally as optimistic, projecting home values to increase by 8% this year.
I don't think anyone really knows how many foreclosed homes Bank of America still has on its books, but what I am certain of is increasing housing prices is a very good thing for Bank of America, which was at the heart of the housing crisis. A 14% increase in home prices would mean that a tremendous number of the foreclosed homes on Bank of America's balance sheet will no longer be under water. As for exactly how good that news is up for debate, and I don't even think Brian Moynihan really knows how many foreclosed homes are still on the company's books.
If the company can manage to recoup a fraction of its pre-crisis $50 stock price on the bullish housing market, that's something current shareholders would embrace with joy.
When Bank of America was strong armed to buying Merrill Lynch in 2008 for $50 billion, it was widely believed that Bank of America was getting ripped off. However, a lot has changed since 2008 and Merrill Lynch is looking like a very smart investment. From 2009 to 2011, Merrill Lynch has made $164.4 billion in revenue and $31.9 billion in total profits. Bank of America in that time, as a total entity, has made $326.8 billion in revenue and $5.5 billion in profits.
Merrill Lynch is still going strong with investment banking fees up 20% from the third quarter and after being up 17% in the second quarter. Furthermore, Bank of America's Global Wealth and Investment Management division saw its net income more than double to $578 million for the fourth quarter, from $272 million a year ago and I can't help but think the division is having an incredible start to the new year, with the S&P 500 producing a year's worth of returns in less than 4 months. Merrill Lynch alone had a market capitalization of $168 billion before the financial crisis, which is currently worth more than Bank of America's $135 billion valuation.
Given the events of the last 5 years, it is kind of unreasonable to assume that Merrill Lynch is worth anywhere near its previous valuation of $168 billion, but I think there is a decent possibility that the price Bank of America paid for it is considered a bargain compared to what the company would fetch on the open market.
I view Bank of America as the cheapest big bank in the United States based on valuation. The company is positioned to benefit substantially from the resurging real estate market, a scorching hot stock market and improving M&A activity. I have a 5 year price target of $25 on the company.