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Bank of America (NYSE:BAC) shares have languished of late after a very impressive, multi-year run. Many investors believe the run is over and that BAC doesn't deserve a higher earnings multiple until it has begun to pay a dividend or otherwise continue to return capital to shareholders. However, I disagree. As long as you understand what you are getting when you get long BAC shares it could be a great addition to your portfolio. By this I mean that BAC is not an income stock and is fraught with risks including unprecedented legal issues. These sorts of stocks are not for everyone but with risk comes potential reward. In this article, we'll take a look at some of the potential reward for BAC shares based upon a return to normal risk taking by the bank and the types of returns it could offer shareholders.

This chart is of BAC's return on average assets for the past ten full years and the first half of 2013. Note that all data is from company 10-K filings with the SEC.


(Click to enlarge)

What we see here is pretty telling. The first thing I noticed was the trough in ROAA during and following the financial crisis. We see this metric absolutely dive off a cliff in 2007 and 2008 as ROAA plummeted to eventually become negative as the bank lost enormous sums of money. However, there is a silver lining. Since the bottom in 2010 BAC's ROAA has risen about 60 basis points to right at half a percent in the first half of this year. While no one is satisfied with 50 basis points of ROAA for the long term, the point here is that the bank has done a terrific job of digging itself out of the holes it put itself in during the financial crisis with respect to soured assets and poor decisions made in the early and mid-2000s.

The other important thing to notice is that this chart gives us a sense of a "normal" ROAA for BAC. In the years leading up to the crisis, BAC was producing an average ROAA of about 1.4%. Recall that 2013 has thus far seen ROAA of 50 basis points and it doesn't take a statistics professor to understand that BAC, despite its tremendous rebound in the past couple of years, still has plenty of room to the upside in terms of earnings. Given this and the very steep slope of the ROAA numbers since the bottom in 2010 I'd say that BAC has an enormous amount of room to continue to make improvements in its ROAA in order to make money for shareholders.

So what does this mean for holders of the stock? At the end of the third quarter BAC reported $2.12 trillion in total assets, which was down very slightly from the second quarter and from the comparable quarter last year. If we extrapolate that BAC will continue to hold total assets steady, which it has been doing for several quarters now, and that ROAA will continue to rise, we get some very interesting implications.

The table below shows BAC's projected potential net income and EPS assuming a stagnant $2.1 trillion asset base and a stagnant share count.

ROAA

NI ($B)

EPS

0.80%

16.96

1.58

1.00%

21.20

1.98

1.20%

25.44

2.37

1.40%

29.68

2.77

1.60%

33.92

3.16

If we take a look at the table, we can see that for each 20 basis point increase in ROAA, BAC would see a roughly 40 cent increase in EPS. That is a staggering amount of earnings leverage on the company's asset base and given that BAC's ROAA is still in the doldrums in comparison to pre-crisis years, the numbers on this table aren't so farfetched.

I'm not suggesting BAC will produce 1.6% in ROAA next year or something but what I'm trying to point out is that even if BAC doesn't decide to pay a dividend, the stock could still be worth owning. Consider that if BAC increases its ROAA 20 basis points per year, which it's currently doing with ease, it will be growing earnings at a double digit pace for years to come. Thus, the stock could very well see earnings multiple expansion but even if it doesn't, if the company is earning $3+ in a few years, the stock would be a double from current levels with no multiple expansion.

BAC has its well-publicized issues but this company is in the early innings of its turnaround. One simply needs to look at ROAA to know that there is a lot of earnings upside to this company in the medium term. Given the low interest rate environment that is seemingly never ending and the fact that management has been working to clean up BAC's balance sheet, ROAA in the 1.4%+ range should be possible in the next few years. Even if BAC doesn't build its asset base between now and then, we should see $3+ in EPS in the not-too-distant future.

Source: Bank Of America: The Path To 100% Upside