Shares of Bank of America (NYSE:BAC) have had a fantastic year, rallying over 34% as the bank returns to normalcy after years of dealing with financial crisis fall-out. While legal issues have been growing for banks like JP Morgan Chase (NYSE:JPM) this year, BAC is putting the legal woes behind it after settling many lawsuits, mainly dealing with Countrywide. While there will certainly be some legal issues in coming months, legal problems are no longer the driver of Bank of America, and investors can start to look at the bank's actual fundamentals when making an investment decision. In this article, I want to caution investors who look at a popular valuation technique for banks and determine BAC is cheap: price to book value.
Banks are mostly made up of financial assets where prices are relatively transparent, so for many years, book value has been a decent estimate of a financial company's worth. For companies with long-lived assets or significant brand value (which can have no book value if not outright purchased), reported book value can be of little use. For instance, the carrying value of the Coca-Cola (NYSE:KO) brand is $0, which obviously make's KO's reported book value far different from its actual value. On the other hand, banks mainly borrow via deposits and use those funds to make loans, making a bank's reported assets and liabilities far closer to economic reality.
This is a major reason why investors have bought shares of Bank of America . Since the financial crisis, Bank of America has consistently traded below book value. As of the last quarter (available here), book value stands at $20.50, or roughly 33% higher than current levels. The thought is that to "build" Bank of America would cost $20.50, so buying it at $15.50 is exceptionally cheap and a great deal. Moreover prior to the financial crisis, banks tended to trade at least 20% above book value (as their brand name and human capital was worth something), which would suggest even further upside beyond $20.50.
I see the appeal in the discount to book value investing thesis, and quite often it makes a lot of sense. However, I don't believe price to book is a perfect investing metric, and there are times when a company should actually trade at a discount to book value. Investors seek a required rate of return, based on stock market returns over past century, that figure seems to be about 8-9%. As a consequence, if a company has a return on equity of 8-9%, its stock should trade at around book value. If a company is able to earn 16-18% on book value, a price of 2x book is probably appropriate. During the 2000-2007 boom, banks were able to consistently generate return on equity in the mid-teens if not higher. However, with new regulations like Dodd-Frank and higher capital levels, those returns are no longer attainable.
Many banks generated significant profits through prop trading before the crisis, something the newly approved Volcker Rule forbids. While the Volcker Rule was not as strong as some reformers had hoped, it forces CEOs to certify that the bank is following the rule, that each trading team has a mission statement, and each hedging action has an explicitly stated risk it is hedging. We have already seen most banks likes Bank of America wind down and divest their prop trading arms, which will keep ROE at a historically depressed level. With higher regulation and capital requirements, the performance of financial companies will appear closer to a utility than a growth company.
As the following chart shows, since the financial crisis we have seen a dramatic drop in Bank of America's ROE from its long term 15.4% average. The company is unable to take on the same leverage it used too, which decreases the return on asset multiplier while the most lucrative trading business has been shut down. When you consider that, it is no surprise that ROE is in the single-digits and BAC is below book value.
Last quarter excluding one time items, BAC generated a return on equity of 6.13%, sequentially down from 6.55% in the previous quarter. Rising interest rates have crushed mortgage refinance activity, which generated a lot of fee revenue for the company. Refinancing was particularly strong in the first half of 2013, which will make the beginning of 2014 a challenging comparison, though a steeper yield curve over time will be beneficial for net interest margins. Return on assets has been averaging about 0.7% for Bank of America, and I believe that is a good estimate of the "new normal for banks." While BAC used to generate 1.1% return on assets, the most lucrative activities have mostly been forced out of the business model, making that figure no longer realistic.
Going forward, investors should look for a 0.65-0.75% return on assets at Bank of America. As one of the nation's systemically important institutions, regulators will force BAC to maintain adequate capital with a common equity ratio of at least 10-10.5%. With these factors, BAC has the capacity to generate return on equity of 6.2-7.25% depending on the steepness of the curve and loan loss ratios. I expect a long term average in 6.6-6.8% range.
Should a company that is generating mid-6% returns actually trade at book value? Based on historically required returns, the answer is really no. Thanks to increasingly burdensome regulations, Bank of America stock is worth less than net assets if you want a reasonable rate of return. Based on historical returns, Bank of America should actually trade at 75%-84% of book value, suggesting they are actually valued at an appropriate level between $15.50-$16.50.
While investors may believe that Bank of America should be worth at least its book value, the company has been unable to generate returns on equity to justify a book value valuation. With its current structure and regulatory environment, I do not foresee Bank of America able to consistently generate a 7% ROE let alone mid-teen returns. Unless and until BAC is generating 8%, it should trade at a discount to book value. With its operating profile, I think BAC is fairly valued at current prices and would not buy it on the "cheap relative to book" thesis. I believe investors will do better looking at smaller banks with less onerous capital requirement that are generating better ROEs. Big banks like Bank of America will be laggards going forward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.