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Bank of America (BAC) shares have been hammered since "disappointing" earnings were released last week. Shares are now trading 9.3% below their highs as of this writing, having been crushed for missing analyst expectations. Analysts and investors are worried that BAC's ability to grow revenues in the future is being compromised given that the mortgage market is seen slowing this year versus the torrid pace of refinances that occurred in 2012. Things aren't all bad though and long-term holders of the stock, I believe, will be rewarded once Project New BAC is complete.

To figure out how much BAC is worth, considering the earnings report we received and its future prospects, we'll use a DCF-type analysis that requires some assumptions: 1) earnings forecasts from Yahoo! Finance 2) discount rate of 10%, which is my number 3) perpetual growth of 3%, which is my number 4) dividends of 30 cents next year and increasing by 10 cents annually, also my estimate 5) tangible book value is used instead of the standard book value as I believe it is a better estimate of liquidation value for banks. Please keep in mind that all projections are subject to conjecture and I have made what I believe to be reasonable estimates where necessary. You may disagree with some or all of my numbers but forecasting is open to interpretation.

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$0.98

$1.30

$1.50

$1.72

$1.98

x(1+Forecasted earnings growth)

33.00%

15.00%

15.00%

15.00%

15.00%

Forecasted earnings per share

$0.98

$1.30

$1.50

$1.72

$1.98

$2.28

Equity Book Value Forecasts

Equity book value at beginning of year

$13.46

$14.14

$15.04

$16.04

$17.17

$18.45

Earnings per share

$0.98

$1.30

$1.50

$1.72

$1.98

$2.28

-Dividends per share

$0.01

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

Equity book value at end of year

$13.46

$14.14

$15.04

$16.04

$17.17

$18.45

$19.93

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

$1.41

$1.50

$1.60

$1.72

$1.84

$1.99

Forecasted EPS

$0.98

$1.30

$1.50

$1.72

$1.98

$2.28

-Normal earnings

$1.41

$1.50

$1.60

$1.72

$1.84

$1.99

Abnormal earnings

-$0.43

-$0.20

-$0.11

$0.01

$0.14

$0.29

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

-$0.39

-$0.17

-$0.08

$0.00

$0.09

$0.16

Abnormal earnings in year +6

$0.16

Assumed long-term growth rate

3.00%

Value of terminal year

$5.55

Estimated share price

Sum of discounted AE over horizon

($0.39)

+PV of terminal year AE

$3.13

PV of all AE

$2.75

+Current equity book value

$13.46

Estimated Current share price

$16.21

Before we get into reading the model's results, it's important to note that I used 15% as the annual increase in earnings; I based this number on the fact that Yahoo! Finance's compilations suggest analysts are looking for 22% annual growth in earnings for the next five years and I simply ratcheted this number down for the sake of being conservative.

Given my assumptions, BAC has an approximate fair value of $16.21 per share right now. Given that shares are trading about 39 percent lower than that amount at the time of this writing, shares look like a screaming buy. Before you hit the "buy" button though, we need to understand what this number means.

First, it's important to understand what this fair value calculation really means. It implies that discounting BAC's earnings at 10% to compensate for the time value of money and the risk that the company will not achieve those targets still nets a fair value far above the current trading price. This means that even with a relatively high bar to clear with a 10% discount rate, shares are still way undervalued. In essence, the fair value price is the price at which the company is still a good buy given your discount rate. As BAC is trading below that amount, it passes that test with flying colors.

Second, the $16.21 is not the forecasted price six years from now. That is the net present value of the company's forecasted earnings at a 10% discount rate. Given the company's current forward PE of 9, shares would be trading at roughly $20.50 in 2018 if the forward PE remains the same and BAC achieves earnings of $2.28 per share.

Lastly, if you look at the "Dividends per share" line in my model, you'll see that I'm forecasting BAC will pay $3.30 per share in cash dividends from 2013 to 2018. That implies you've got roughly 28% of the current share price headed your way in cash distributions over the next few years given my assumptions about cash dividends. Of course, nobody can forecast what BAC's dividends will look like for the next 6 years, but I believe the company has the available cash to pay virtually any reasonable dividend it pleases.

The point behind my model's results is that Bank of America is absurdly cheap right now and has only gotten cheaper since the earnings report. With Project New BAC cutting literally billions of dollars out of BAC's cost structure over the next few years, revenue growth isn't even needed to see increased EPS. Couple this with the massive preferred stock redemption the company announced in March along with a $5 billion common stock repurchase program, and it is quite easy to paint a bullish picture for BAC shares. Of course, I believe BAC is going to continue to increase its revenue and that fears of that not happening are overblown but even if the naysayers are right, shares are still pretty cheap. Finally, I'm convinced BAC will institute a respectable dividend next year after it redeems the preferred securities and buys back the $5 billion in common shares this year and once that happens, shares will be much higher than they are today. Indeed, if analysts are right about the 22% growth rate instead of the 15% I used for my model, BAC's fair value is more like $22 today. I think that's a bit optimistic but the point stands.

Source: Bank Of America: Why It's Going Higher