Bank of America (NYSE:BAC) fans have and continue to stress how cheap the bank is trading compared to peers on a book value basis. But I have argued, and will continue to argue here that the bank is much more expensive (or fairly valued) than a cursory P/B ratio would lead investors to believe. Want to get savvy? Ok, try, but even a price to tangible book value will leave you astray. Why? Before twenty thousand eyes start to roll, I warn you, this is an accounting related issue. And, not the kind that was hidden in an acquisition technical miss. This one is hiding in plain sight and it goes by the name of Deferred Tax Asset.
Fresh off of tax season, I know the last thing that you want to do the month after is go over anything tax related, but let's think about this asset in a non-business sort of way.
You've likely used coupons and if you haven't, you've at least heard of them so let's use them as common ground for this example. Now, let's say that you and I have an agreement where you owe me 35% of all of your future earnings and that you have a coupon issued by me with a face value of $40 billion for some of this debt. You have various businesses spread out all over the world and even though this coupon says it's good for $40 billion, we have agreed that it can only be applied to certain streams of your revenues based on profitability. Unfortunately, due to this complexity, we can never know exactly how much of the coupon you are going to use each year, but I have agreed to allow you to use it for up to 20 years.
As an aside, the present value of a 20-year, $2 billion annuity discounted at 10% is ~$17 billion.
Continuing, let's also say that in the normal course of business you need a loan and to get that loan you need to draw up a balance sheet for your bank as part of the application process. Do you include this coupon in the list of your assets and equity? If you do, do you put the face value or a lower estimate of its present value? You certainly would want to include it in proforma cashflow statements, but if you're like most bank analysts your told to stay away from cashflow statements because this is a financial institution and that form is a black hole. What to do, what to do?
How about the income statement? Not so fast, this has already run through earnings because the past losses weren't registered at full value because of these future savings.
So, here we are, with a coupon in one hand and 1) no telling when we can use it and 2) how to value it. What we do know, however, is not all of it will be used next year or the year after that and that it has already helped out our past earnings when it flowed to retained earnings and created the new non-earning asset.
Moving back to Bank of America, the full value of this net deferred tax asset is being used to compare the bank's value to other banks that don't have one at all (like Wells Fargo (NYSE:WFC)). We have no problems writing off goodwill to get to tangible assets and equity, but why does this non-earning asset get to stick around? Even regulators are phasing them out of their Tier 1 Capital calculations.
In addition to distorting value, the deferred tax asset is of zero use for investors trying to calculate returns and liquidity. Bank of America has a goal of hitting a 1% return on tangible assets in the next couple of years, but this asset is making no money and I doubt management is including it on any of their internal scorecards. Why would they? The inclusion of them in equity actually brings returns down.
Hidden returns may sound good when taken at face value, but it means BAC shareholders may need to revise their earnings power estimate because the bank may actually already be closer to their goal which, right now, doesn't add up to much.
Bank of America shares have fallen to ~1Xs reported tangible book value, but I remind you, if the tax assets were treated like goodwill you would strip out that $40 billion (bringing it to closer to 1.48Xs) before you even think of comparing it to Wells Fargo.
You may or may not agree with me, but you invest with your money and you are responsible for your own opinions. I've been able to find a few others who share my view on this particular issue and I'd like to close with one that is from Leucadia's (NYSE:LUK) 2005 Shareholder Letter (this, I would like to point out was the opening paragraph):
Thanks for reading, this is not an attack on Bank of America and was only written to help shed light on a complex accounting issue.
Disclosure: I am long BAC, WFC. 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.
Additional disclosure: I am long BAC and WFC through warrants.