Bank of America (BAC) famously cut its dividend to one cent per quarter in the wake of the effects it suffered as a result of the financial crisis. Shareholders have been clamoring for a dividend increase since BAC came out of the throes of the worst of the crisis and has solidly returned to profitability. Following the Federal Reserve's CCAR results, some investors were disappointed that BAC went with massive preferred securities redemptions and common stock repurchases over an increased dividend. Regardless of your feelings on the capital return plan, it is important to note that BAC will raise its dividend at some point, probably in 2014. When this happens, we as investors need to know what BAC can afford to pay in order to ascertain what kind of yield the shares may carry.
Financial service companies, more than any other industry, report earnings that are riddled with non-cash accounting items that distort the true health of the bank. For instance, provisions for credit losses are reported as a loss of net income even though no cash has exchanged hands. For BAC in 2012, this item alone decreased net income by $8.2 billion. There are others that wreak havoc on a bank's earnings that distort the true picture of how much cash a bank is actually generating. This is important for the dividend as cash dividend payments are not made from "earnings"; rather, they are paid from cash generated by the business or some other financing means. Therefore, it is more important, in my view, to know how much cash a business is generating in order to evaluate how much of a dividend the company can afford.
While I think it is nonsense, the payout ratio is monitored by millions of investors. This arcane measure is simply the amount of dividends paid divided by the amount of net income the business reports. I call it nonsense because of the fact that no business in the history of the world ever paid a cash dividend from its earnings. Net income is an accounting metric that is intended to provide a complete picture of a business's financial performance over a period of time. For certain businesses, it may closely resemble the cash generated from operating the business; for a bank, this is rarely the case.
We'll start with the payout ratio, as it is still important despite its lack of logical support. BAC's payout ratios for the past six years are below.
We can see that since BAC's profitability began to nosedive and eventually go negative during the financial crisis, its payout ratios have fluctuated wildly. The two most "normal" years in this data set are 2007, just before the financial crisis, and 2012, when BAC's business was beginning to revert back to "normal" for the bank. Among dividend payers, 74% and 69% are relatively high payout ratios. However, we will see next that these numbers are a bit misleading.
For a bank such as BAC, my preferred measure of the cash-generating abilities of the company is simply the operating cash flows the company reports. Basically, this is the amount of cash the company's assets generated over a period of time. It begins with net income and then backs out all of the non-cash losses and gains that distort net income and make it pointless for evaluating a company's ability to pay a dividend.
In BAC's case, we can see below in the comparison of operating cash flows to net income that the business generates far more cash from its operations than net income would suggest.
We can see that net income and operating cash flows generally have little correlation with one another. For instance, 2009 through 2011 saw net income of negative $5.7 billion while operating cash flows totaled $277 billion! While I'm not suggesting that BAC actually "earned" $277 billion during that period, it is important to note that this cash generated by the bank allows it to use it to invest and finance the activities it needs for the future. Included in that bucket of activity is share repurchases, debt redemptions and cash dividend payments.
Below, we can see the cumulative amounts of net income, dividend payments and operating cash flows the bank reported during our data set period.
While it may appear at first glance the three numbers are relatively similar, it is important to note the scale on the right side of the graph. The green line is the cumulative operating cash flows the company reported from 2007 to 2012 and the number is $279 billion! For reference, BAC has reported $14.4 billion in net income over that period and paid $33 billion in cash dividends. The point of this graph is to put into perspective the uselessness of the payout ratio. By this measure over the past six years, you'd think BAC could never afford another dividend payment; that is simply not the case.
At this point, it is important to note that the cash generated by BAC's operating activities is used for investments, such as purchasing assets, and financing activities, such as repurchasing debt or common stock, paying dividends and the like. Therefore, it is not as though BAC has an extra $277 billion lying around from the past six years because if it didn't reinvest at least some of that money, the business would slowly die off. The critical point in all this is that BAC has plenty more cash available to pay dividends than net income would suggest.
Currently, BAC is choosing to use the cash it doesn't need to invest in the business to repurchase preferred securities and common shares. However, assuming the business begins to generate more cash or that BAC decides not to renew its share repurchases, for instance, it will have more cash available to pay a cash dividend on the common stock.
If we simply assume that BAC finishes up its preferred securities redemption mentioned earlier, it will have $5.5 billion available next year to potentially pay a common stock dividend without any additional financial strain in comparison to this year. In addition, management may decide not to renew its common stock repurchase program, assuming it is completed by next year, which would free up another $5 billion. If we just use the $5.5 billion potentially available from the cessation of the preferred redemptions, with BAC's current 10.822 billion shares outstanding, a $0.51 annual, or roughly $0.125 quarterly, dividend is very possible. At BAC's current price, that would imply a yield of 4.3%. If we include the $5 billion from the share repurchase program, that yield could roughly double. Of course, I don't anticipate BAC yielding 8%, but as we have seen, BAC can easily pay $5.5 billion in cash dividends per year for an enormous yield greater than twice the 10 year Treasury rate.
If this were to happen, once the market figures out that BAC is planning on a $0.12 quarterly dividend, the stock will be bid up in response to lower the yield to perhaps 3% to more closely match the bank's peers. Therefore, if my calculation of a $0.12 quarterly dividend proves correct, we could see BAC yielding 3% in addition to the price of the stock rising to $16. This is the one-two punch that is an investor's dream; capital appreciation and a robust dividend.
After BAC went with the above capital plan following the CCAR results, I'm quite confident we won't see a dividend increase this year. However, 2014 is a new opportunity and since BAC won't have $5.5 billion in Preferreds to redeem, I think a huge dividend is in the offing. Time will tell, but if you wait for the announcement, you will be paying much higher prices than you would today.