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If you are a long-term investor who owns an excellent company purchased at a value price, the question of what to do when the stock reaches fair value is pretty easy to answer. You kick back, cash the dividend checks that come your way every ninety days, and let the organic growth of the high-quality firm be the source of your returns going forward.

A much more interesting question is what to do when a second-tier firm purchased at a value price roughly reaches your perception of fair value. Such is the case that Bank of America (NYSE:BAC) presents today. Although classifying the quality of companies is an inherently subjective endeavor, I felt comfortable putting Bank of America in the second-tier category because, despite its tremendous earnings power, it still carries the legacy of a company that diluted shareholders roughly 100% between 2007 and 2009 (by increasing the share count from 4.4 billion to 8.6 billion) and the current dividend of $0.04 annually is the ever-present reminder of the bank's woes five years ago have not been fully conquered.

Given Bank of America's current share price of $15.63, what kind of future profits will current owners generate in relation to the current price of ownership?

To answer that question, I first try to get a hold of Bank of America's current earnings power, which has been slippery to define simply because of constant litigation settlements and asset reshuffling that have made it difficult to get a handle on what a normal earnings period looks like for Bank of America the business.

Here is what I see: when you strip out the $1.1 billion in recent litigation settlements, the one-time charges associated with ending the careers of 1,000 now former employees (as part of "Project New BAC"), and the $0.08 per share detriment that affected the commercial and auto loan divisions, we have a company that is making slightly above $11 billion per year in profit on a normalized basis. One thing worth clarifying - I am not trying to be dismissive of the very real problems that Bank of America has faced, but I am trying to assess the company's true profit-generating potential going forward, and I do that by removing expenses that are part of clearing out the underbrush from the financial crisis so I can gauge what the company might be doing five, ten, fifteen years from now.

Given that Bank of America seems to have current earnings power of roughly $11 billion, we need to adjust for the fact that the company is currently divided into 10,683,282,112 pieces. That means each share you own represents $1.03 or so worth of earnings power.

Historically, Bank of America trades at a P/E ratio of 11-12x earnings when you make the common-sense judgment of removing the outlier years from your analysis (the P/E of 18.6 in 1998, 15.0 in 2007, and the years since the crisis in which the bank's profit has been negligible is not useful to include because the first two count excessive valuations and the latter reflects meltdown risk no longer present in the bank, as judged by its bolstered Tier 1 Capital Ratio).

If we use 11-12x earnings as our guideline, we might be inclined to reach the conclusion that Bank of America's fair value is somewhere around $11.33-$12.36 per share. But that analysis is incomplete because it does not take into account the potential that Bank of America might have "pent up" profit that is yet to materialize.

I'll give a few examples of what I have in mind. For instance, Bank of America has been slashing its workforce aggressively. The expectation is that this workforce reduction will cause the company to save almost $1 billion worth of costs over the next three years.

And, of course, the biggie: right now, we are living in a time of extraordinarily low interest rates. If you believe that interest rates will increase, then Bank of America's interest income could rise substantially. Company-wide, if we see a reversion to the mean wherein interest rates go up by a couple of percentage points, we could see Bank of America's return on assets increase from 0.50% to 0.75%, and that could turn Bank of America into a company making $15-17 billion within years or so from now. A belief in imminently higher interest rates might justify creeping above Bank of America's historical valuation mark because of the pent-up profit represented by the current low interest rates.

Another method of evaluating Bank of America that proves intriguing is traditional book value analysis. The old Wall Street adage is that you buy a bank when it trades at half of its book value, and sell when it is trading at twice its book value. In the case of Bank of America, the book value is currently at $20.80 per share. At a current price between $15 and $16 per share, that might suggest that Bank of America is moderately undervalued and a potential candidate for purchase.

What catches my interest is the potential for dividend growth. Bank of America's earnings per share is finally showing signs of lending itself to a boost in the penny per share dividend. In 2009, the company lost $0.29 per share. In 2010, the company lost $0.37 per share. In 2011, the company made a penny per share. In 2012, the company made $0.25 per share. Now, when we do include the one-time events, the company is poised to make $0.85 per share by year end.

While I am not on the Board of Directors, my current estimate is that the annual dividend will rise from $0.04 per share to $0.28-$0.44 per share within the next two to three years. Absent new one-time items of significance, that would give Bank of America a comfortable dividend payout ratio in the 30-40% range, giving the company some breathing room to safely start a tradition of annual dividend growth again. The resumption of the dividend could be useful in setting an informal floor price for the stock, perhaps mitigating the cowboy-ride of volatility that the stock has given investors in recent years.

The take-home message is this: Bank of America is currently somewhere between slightly undervalued and slightly overvalued, depending on the analysis method you prefer. However, if you reach the conclusion that large one-time items are behind the company, and if you believe that interest rates are likely to rise in coming years, then Bank of America falls more clearly on the undervalued side. If you currently own the shares, it may be worth hanging on to them for the next couple of years as the company is finally demonstrating the earnings power necessary to begin paying shareholders a decent-sized dividend.

Source: What To Do With Bank Of America Now