Fair Value of Bank of America: A Flaw in Paulson's Calculation?

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Includes: AXP, BAC, BK, COF, GS, JPM, MS, STT, WFC, XLF
by: Jacob Wolinsky

Bloomberg recently reported that John Paulson believes BAC still has a large potential upside. He expects the stock to double in the next two years from its current price of $16. Paulson is basing this on $3 per share earnings for 2011 and a 10X multiple which equals $30 per share. Below is some data detailing how Paulson got some of his numbers.

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I discovered a major flaw in the data Paulson used. Bank of America received $45 billion in TARP money from the government which it has not paid back yet. To pay this money back, Bank of America is going to have to raise $45 billion. To get completely out of the government's control Bank of America will have to buy back the warrants from the government. This company may have to raise slightly more tan $45 billion to accomplish this. This will be accomplished either through issuing new stock or issuing debt. I have compiled some data on several of the large banks that have repaid TARP so far.

Company TARP Received Common

Stock Issued

JP Morgan (NYSE:JPM) $25 Billion $5.75 Billion
Goldman Sachs (NYSE:GS) $10 Billion $5 Billion
Morgan Stanley (NYSE:MS) $10 Billion $6.9 Billion
US Bancorp (NYSE:USB) $6.6 Billion $2.5 Billion
Capital One (NYSE:COF) $3.6 Billion $1.75 Billion
American Express (NYSE:AXP) $3.4 Billion $5 Billion
BB&T (NYSE:BBT) $3.1 Billion $3.1 Billion
Bank Of NY (NYSE:BK) $3 Billion $1.2 Billion
State Street (NYSE:STT) $2 Billion $2 Billion
Bank Of America (NYSE:BAC) $45 Billion ????
Click to enlarge

Except for JP Morgan and American Express, most of these companies raised about half their money from common stock issuance. This list does not include the companies that were ordered to raise capital but are not yet allowed to repay TARP. Wells Fargo (NYSE:WFC) was ordered to raise $13.7 billion to be adequately capitalized. Wells Fargo raised more than 60% of this amount through stock issuance. I think it is fair to assume that Bank of America will likely have to raise around $25 billion in common stock (the rest in debt), which is slightly more than half the amount it received from the government. Bank of America has 8.6 billion shares outstanding. Paulson uses nine billion shares outstanding in his data, I do not know where he got this figure from - it could be he assumes a future issuance of 400 million shares to repay TARP. However, if Bank of America has to raise $25 billion in a common stock offering envisioning today's price of $16 per share, they would have to issue about 1.6 billion shares. This would equal 10.2 billion shares outstanding and reduce EPS to 2.66 (net income 27.2 billion divided by 10.2 billion shares). If Bank of America raised $35 billion in stock it would increase shares outstanding to 10.8 and reduce EPS to 2.5.

There are two other major factors that could adversely affect EPS. I am assuming Bank of America is able to sell common stock at $16 per share. If its stock declines to $12 per share before its issuance, the company would have to issue far more shares. To raise $25 billion it would have to issue 2.1 billion shares reducing EPS to 2.54. If it had to raise $35 billion in stock EPS would be 2.36.

The second major factor which must be considered is Bank of America needing to raise more than the $45 billion it received in TARP. Under the original stress test results Bank of America had to raise $33 billion besides the $45 billion it received from the government to be well capitalized. The stress test assumed a maximum unemployment rate of 10.3%. With unemployment currently at 10.2% and continuing to rise that now looks like an optimistic number. If unemployment rises more the government might force Bank of America to raise even more money.

There are variable factors at play and therefore it is impossible to calculate with precision Bank of America's future EPS. However, based on probable future dilution it looks like Paulson's EPS estimate might be a bit too optimistic. This would make Bank of America's share price at 10X multiple closer to the low or mid 20s, and not $30 as Paulson predicts. With all these uncertainties combined with the likelihood that BAC will be under severe financial stress in the near future, suddenly BAC looks a lot less attractive.

Disclosure: I am long WFC, JPM, GS, USB, AXP