Bank of America (BAC) is up 39% over the past 12 months with tailwinds from a positive macro environment, strong quarterly earnings and guidance revisions from managements. I believe that the US recovery prospects are the key to stock performance over the next months.
(Source: Yahoo Finance)
Improving economic conditions will certainly boost the investment and saving activities which will probably result in more revenue. On the other hand, the long-term interest rates will continue to rise in anticipation of the Federal Reserve's tapering of asset purchases, and rising rates may support banks' profitability through its effect on net interest margins (NIMs). The rate banks charge borrowers generally rises more quickly than their own cost of funding that may lead NIMs to further surprise the market to the upside. I also expect that the bank will be enjoying a higher loans to deposits spread in the process of economic recovery.
On the asset quality side, we saw a pick-up in Basel 1 Tier 1 common capital ratio which is up to 11.19% as of the end of 2013. In other words, Bank of America's balance sheet has significantly strengthened.
There are also some key developments in the near future that will be able to strongly influence the share price.
Firstly, with the decreasing expenses as a part of its "Project New BAC Program", Bank of America has the opportunity to raise its operating profitability through increasing the efficiency. Reducing the costs is one of the main targets of this program. Additionally, the bank is said to cut 450 mortgage jobs. This is just one example showing that the management will be loyal to its cost reduction strategy.
Secondly, the bank will likely raise its dividend payments. Being a systemically important financial institution, the bank is obliged to seek approval from the Federal Reserve for doing dividend payments. The bank has been forced to pay an inglorious $0.01 quarterly dividend since 2009. In 2011 the bank asked the Fed for permission to raise the dividend but was denied. Some Wall Street analysts forecast that Bank of America will ask again to pay shareholders. Considering the strengthening financial structure of the Bank of America, I believe that the Fed will grant permission to the bank to gradually raise the dividend.
Thirdly, legal issues are the perceived high risk factors that investors should take a deeper look into. Bank of America is still facing legal issues regarding sub-prime mortgage crisis which would take several more years to be resolved. The bank has already struggled under the weight of legal settlements and spent a total of $20.1 billion over the last five years on legal fees and litigation expenses. This is certainly the top issue on the table which also keeps the stock undervalued. Any investor holding Bank of America stocks, or more generally bank stocks, has to face the challenges arising out of legal woes. I think the bank's management experienced a lot in this area and now knows how to minimize the impact of legal costs on its profitability by practicing effective cost management strategies.
Bank of America is trading at 10.9x price to earnings ratio, and at 0.8x price to book value per share ratio. Comparing it to its peers, particularly the low P/BV, suggests that Bank of America is definitely undervalued. This is mostly because of the legal issues that I explained above. With forward thinking, I think now is the time to buy the already undervalued stock before all this legal mess comes to an end.
Not surprisingly, the analyst estimates for Bank of America are also suggesting further potential upside in earnings per share to $1.62 at the end of 2015 that means 65% increase in two years. The estimates also signal a 3.9% increase in revenues within two years. Based on these assumptions and given the catalysts above that build a supportive case for Bank of America, I believe that the stock might hit $24 within two years. The bank has been surely showing robust growth and will continue do so in the upcoming quarters. Despite the legal woes, incrementally growing earnings, and the cost reductions program will boost the profit.
Finally, but most importantly, be reminded that investors will look to Bank of America as a play as the US recovery continues.