Bank of America (NYSE:BAC) has seen plenty of recent news that has affected earnings. Just taking a stroll through BAC's SA news page reveals several material events in just the past couple of weeks including never-ending litigation and layoffs. I won't go through those issues here as you can read about them on SA and I've also written a number of articles on the issues. However, I do think it's instructive to, after having digested this information, take a look at BAC's new earnings estimates in the context of long-term value for shares. In this article, I'll update my forecast for the long-term intrinsic value for the bank.
To do this, I'll use an earnings model I've used numerous times before, the mechanics of which you can read about here. In essence, the model uses various inputs like book value, earnings estimates, dividends and a discount rate in order to determine what the company's future earnings are worth today, computing intrinsic value for shareholders.
Something I do for banks with the model that is different from non-banks is that I use tangible book value instead of traditional book value. I do this because tangible is a better measure of a bank's true worth, in my opinion, as traditional book value includes many assets that cannot be used to generate revenue. In addition, I used the discount rate of 8.5%, reflecting our low interest rate environment plus an equity market premium and for earnings estimates, I used those from Yahoo Finance. Finally, I took a shot at dividends for the next several years but as we all know, there is absolutely no way to forecast those as I'm relatively certain management doesn't even know what they'll be.
Prior Year earnings per share
x(1+Forecasted earnings growth)
=Forecasted earnings per share
|Equity Book Value Forecasts|
Equity book value at beginning of year
|Earnings per share||$0.92||$1.51||$1.65||$1.79||$1.95||$2.13|
|-Dividends per share||$0.01||$0.20||$0.30||$0.35||$0.40||$0.50|
|=Equity book value at EOY||$13.81||$14.72||$16.03||$17.37||$18.82||$20.37||$22.00|
Equity book value at begin of year
|x Equity cost of capital||8.50%||8.50%||8.50%||8.50%||8.50%||8.50%||8.50%|
|Future abnormal earnings||-$0.25||$0.26||$0.28||$0.32||$0.36||$0.40|
|x discount factor(0.085)||0.922||0.849||0.783||0.722||0.665||0.613|
=Abnormal earnings disc to present
|Abnormal earnings in year +6||$0.40|
Assumed long-term growth rate
|Value of terminal year||$7.25|
|Estimated share price|
Sum of discounted AE over horizon
|+PV of terminal year AE||$4.45|
|=PV of all AE||$5.12|
+Current equity book value
=Estimated current share price
As you can see, the model computes a fair value for shares of about $19, or nearly $4 higher than where they trade today. That is a large discrepancy but I believe it is quite fair given my inputs and some fundamental reasons we’ll get into in just a moment. But before we dig in, it’s important to understand that the value I’ve just computed is not a price target. Rather, it is a fair value for shares today. In other words, the model says you should buy BAC shares today as long as they are trading south of $18.93, which of course they are.
So why do I think $19-plus is realistic? First off, I think the recent reductions in earnings estimates are too aggressive. If you look at the analyst estimate page I linked to above you can see that 2014 estimates have been cut hard for the past few months. The main reason its BAC’s ongoing litigation issues and namely, the mortgage nightmare that won’t go away and has a reported price tag near $15 billion. This alone will remove billions of dollars from earnings, likely in 2014, depending on how much BAC is reserved for such losses. This is still the biggest wildcard for earnings by far as we don’t know when a settlement will take place, how much BAC is already reserved for such an event and what the final price tag will be. However, I think earnings estimates are forgetting just how profitable BAC is without this litigation nonsense.
The bank has tremendously improved fundamentals even from 2013 as earnings are improving greatly at several of BAC’s business units, including Global Markets and Global Banking, among others. However, the biggest reason I think earnings estimates are too low is that BAC’s legacy asset business, which has been hemorrhaging billions upon billions of dollars for years now, is starting to turn up. Losses are down sharply and while still gargantuan by any measure, should be close to breakeven in 2015 or 2016. BAC doesn’t need LAS to make money, it just needs it to stop losing so much money. LAS has been routinely removing 50 to 70 cents of EPS in the past several years and if LAS would just breakeven, BAC’s earnings would take off. I think LAS is closer to breakeven than what is currently being forecast and with BAC’s profit growth in other areas as highlighted above I think BAC can beat the lowball earnings estimates.
Finally, the earnings model doesn’t take into account any share repurchases the bank may make in the coming years. While buybacks will likely be muted due to stress test restrictions, repurchasing a few percentage points of the float will allow earnings estimates to be ratcheted higher. This will be a 2015 and beyond phenomenon as buybacks for 2014 have been squashed due to BAC’s capital miscalculation earlier this year. However, when buybacks resume, there is upside to earnings estimates.
Owning BAC is not for the faint of heart. Ongoing litigation issues and the fact that BAC still owns hundreds of billions of dollars worth of underperforming loans as relics of the financial crisis mean that shareholders are in for a potentially wild ride over the next few quarters. However, I think sentiment has become so bad on BAC that the bottom has been made earlier this year and that we’ll see shares trading up near $19 and beyond in 2014. Once the issues we’ve discussed pass and investors focus on earnings again, I think we’ll see shares experience some multiple expansion and a march toward $20.
Disclosure: The author is long BAC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.