Seeking Alpha
Long/short equity
Profile| Send Message|
( followers)  

Bank of America's (BAC) stock price shows that business is booming. In addition, I think a strong case can be made that despite the new highs being seen, there is still a lot of value in BAC shares. One way I think some value can be seen is in the company's return on assets, a key metric in banking. In this article, we'll take a look at BAC's return on average assets and its average earning assets in order to determine where both are headed and what it may mean for BAC's earnings potential.

To start, I pulled BAC's return on average asset and average earning asset data (in $ millions) from its SEC filings for the past ten years. Return on average assets is exactly what it sounds like; it's the company's return on its average outstanding assets for the year. It uses average assets instead of the balance sheet number that is reported so it is a more accurate measure of profits than simply computing return on assets based on a static number reported at the end of a quarter. Second, the average earning asset number is the company's average outstanding assets from which it can earn a return. In other words, this doesn't include things like equipment, office space and the like that BAC owns but can't earn anything from. Again, this is a more relevant picture of a company's asset base than total assets. The results for BAC are below.

(click to enlarge)

To be sure, there are some interesting numbers on this chart. First, we see BAC's average earning assets in 2004 below $1 trillion but that number rapidly expands to nearly double that amount in 2010. At the same time, we see BAC's ROAA go from a steady ~140 basis points to 100 and then, as the financial crisis hits, 25 basis points. During the depths of the mortgage crisis BAC found itself in, ROAA was actually negative, albeit slightly, before rebounding to be barely positive in 2011.

Where it gets interesting, and I think most relevant, is the period of 2010 to the present. In 2010, BAC had its peak average earning asset number but also posted a loss on those assets. As we all know, the stock price eventually reflected this at $5 per share; it was a rough time indeed for BAC. However, two interesting things have happened since then. First, BAC has been steadily shrinking its average earning asset base from the peak, going from $1.9 trillion to where it stood during 2013 at $1.75 trillion. You would think this would be bearish for a bank as it obviously needs an asset base to earn money from. However, there is more at play here. If we look at the ROAA bars we see that this metric has skyrocketed since the trough in 2010 and in fact, 2013 was the best year (by far) since 2007, before the mergers with Countrywide and Merrill Lynch and also before the financial crisis took full effect. This is indicative of BAC's efforts to divest the riskiest of its assets and thus, shrink the asset base while still increasing overall profitability through fewer losses on the portfolio. I think the evidence is pretty clear the strategy is working and the share price reflects as such.

So what does this mean for the company going forward? I think the asset base is going to remain steady around $1.75 trillion because we haven't seen it budge much from that level in recent times. The decreases in the earning asset base were pretty rapid at first but have since slowed significantly and in the past few quarters, remained quite steady. Thus, for this exercise, I'll use $1.75 trillion as the base for the earning asset pool.

The ROAA piece is where it becomes even more interesting as you can plainly see BAC is still nowhere near its earning potential on its asset base. For this exercise, I'll use a few different hypothetical ROAA levels in order to determine what kind of profits could accrue to BAC on its earning asset base. The results are below.

ROAA

Net Income

EPS

0.4%

7,000

0.65

0.6%

10,500

0.98

0.8%

14,000

1.30

1.0%

17,500

1.63

1.2%

21,000

1.96

1.4%

24,500

2.28

1.6%

28,000

2.61

When looking at the table above it is important to realize three things. First, the table is computing EPS from the earning assets only. In other words, all other income including noninterest income is removed from the equation to focus simply on the company's ability to earn money from its asset base. Second, the baseline is closest to the second line with 60 basis points of ROAA. Lastly, the chart assumes a stagnant $1.75 trillion earning asset base, as discussed earlier.

The implications of increasing the return on its asset base are enormous for BAC. We can see that each 20 basis point increase in ROAA produces a prodigious $3.5 billion increase in net income, roughly equivalent to 33 cents per share in earnings. That is an astounding amount of earnings leverage and keep in mind this all assumes BAC doesn't grow its asset base ever again.

So how realistic are these numbers? Consider that BAC was routinely doing 140 to 150 basis points in ROAA before it took on Merrill and Countrywide and that 2013 saw only 53 basis points in ROAA; there is an enormous amount of room for expansion here. In addition, BAC is already optimizing its workforce, reducing its credit losses, and net interest margin is on the rebound. There is plenty to be excited about here and the story is a good one. More so than any of the other big banks BAC still has enormous room for improvement on its key metrics.

With BAC's earning asset base seemingly stabilizing over the past several quarters and all of the other positive factors discussed, including a ratcheting up of ROAA, BAC shares should be poised for further gains. ROAA could eventually triple from its 2013 level and while that is a long term goal, I think a more realistic near term goal is to get ROAA to the 100 basis point mark. At that point, we're talking about an increase in EPS of about 76 cents over 2013's level. That alone would account for nearly $8 of additional upside given BAC's 10+ forward earnings multiple. That is astounding considering that this number represents nearly 50% upside from today's levels. Given the progress BAC is making on all fronts, I don't see it as a long term goal either; it's more of a near to medium term target and I think we'll see shares higher as a result.

Source: How Bank Of America Reaches $25