Bank Of America - Free To Power Up To $20 By Next Year

Aug.28.14 | About: Bank of (BAC)

Summary

BAC has settled the remaining large lawsuit with the government and is now free to focus on running its business.

Large projected capital returns for next year along with an improving chart set BAC up for increased investor interest.

Fundamentals are also improving and we could see BAC beat its consensus of $1.50 in EPS next year.

Bank of America (NYSE:BAC) shareholders have been through a lot in the past few years. Between the crisis decimating earnings and the subsequent lawsuits that have plagued the bank ever since, BAC's stock has been held down by continuously bad news and expensive legal bills. Well, after BAC settled its largest lawsuit, I think that cycle of (expensive) negativity may actually be coming to an end and that means investors can go back to focusing on BAC's business instead of its legal tab. In this article, I'll take a look at BAC's valuation in light of its prospects to see if it really is cheap or if earnings have some catching up to do.

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To do this I'll use a DCF-type model you can read more about here. Basically, the model takes inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at 20 cents higher next year and 10 cents of growth annually thereafter, and a discount rate, which I've chosen as a 6% risk premium over the 10 year Treasury rate. The dividend is particularly difficult to forecast given BAC's reliance on the CCAR process for Fed approval but I feel like these numbers will be pretty close to actual.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$0.90

$0.80

$1.50

$1.62

$1.75

$1.89

x(1+Forecasted earnings growth)

-11.10%

87.50%

8.00%

8.00%

8.00%

8.00%

=Forecasted earnings per share

$0.80

$1.50

$1.62

$1.75

$1.89

$2.04

Equity Book Value Forecasts

Equity book value at beginning of year

$21.17

$21.77

$22.87

$23.99

$25.14

$26.33

Earnings per share

$0.80

$1.50

$1.62

$1.75

$1.89

$2.04

-Dividends per share

$0.20

$0.40

$0.50

$0.60

$0.70

$0.80

=Equity book value at EOY

$21.17

$21.77

$22.87

$23.99

$25.14

$26.33

$27.57

Abnormal earnings

Equity book value at begin of year

$21.17

$21.77

$22.87

$23.99

$25.14

$26.33

x Equity cost of capital

8.40%

8.40%

8.40%

8.40%

8.40%

8.40%

8.40%

=Normal earnings

$1.78

$1.83

$1.92

$2.02

$2.11

$2.21

Forecasted EPS

$0.80

$1.50

$1.62

$1.75

$1.89

$2.04

-Normal earnings

$1.78

$1.83

$1.92

$2.02

$2.11

$2.21

=Abnormal earnings

-$0.98

-$0.33

-$0.30

-$0.27

-$0.22

-$0.17

Valuation

Future abnormal earnings

-$0.98

-$0.33

-$0.30

-$0.27

-$0.22

-$0.17

x discount factor(0.084)

0.923

0.851

0.785

0.724

0.668

0.616

=Abnormal earnings disc to present

-$0.90

-$0.28

-$0.24

-$0.19

-$0.15

-$0.11

Abnormal earnings in year +6

-$0.17

Assumed long-term growth rate

3.00%

Value of terminal year

-$3.16

Estimated share price

Sum of discounted AE over horizon

-$1.76

+PV of terminal year AE

-$1.95

=PV of all AE

-$3.71

+Current equity book value

$21.17

=Estimated current share price

$17.46

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As you can see, the model produces a fair value of around $17.50, or around 8% higher than shares trade for right now. That is a decent margin of safety so let's take a look at what it means and how the number was derived.

It's important to understand the number produced is a fair value and not a price target. A price target is a multiple of EPS projected out into the future at some point; the fair value I've computed is what shares are worth today. In other words, the present value of BAC's future expected earnings stream, adjusted for dividends, is $17.46, according to the inputs I described above. That leaves a nice margin of safety between the fair value and the actual price today.

So that means we should be buying right? I happen to think so (obviously) but let's take a look at why. First, if we look at the chart above, we can see that BAC shares, after having fallen precipitously from $18 to $15, have sprung right back above $16 following the settlement news. This is great for a couple of reasons. The first one is that it means shares have made a higher high than the previous spike in July and it also means the series of lower highs since that July peak was broken.

Second, it means that the 50 DMA is now poised to overtake the 200 DMA if shares can trade around the $16 area or higher for a couple of weeks. That would be the golden cross investors so often watch and that could be the catalyst for additional money coming into the stock. I don't happen to put much into the golden cross or death cross theory but many investors do, so it is worth watching as it could mean additional buying pressure once it occurs.

BAC's fundamentals are also ever-improving. The bank has struggled with EPS for years due to the horrible acquisitions it made during the crisis and the constant stream of multi-billion dollar legal bills it was forced to pay. However, underneath all of that there is a bank that is solid, earning money along the way and setting shareholders up for a nice few years of earnings growth. BAC has been an underperformer in all basic banking metrics such as return on assets and net income because it has struggled so mightily with its legal bills.

The fact that the legal distraction is now gone means management can focus on making money and serving customers instead of fighting off advances from the government and others. It also means billions of dollars of capital is now freed up to invest in the business or return to shareholders. Apart from fundamentals, which I believe are quite strong for BAC, even in a low interest rate environment, it is now free to return more capital to shareholders.

BAC has been hostage to its legal woes for years now and that was a big reason why it paid virtually no dividend for the past several years. With the Fed having to approve any and all capital returns to shareholders, BAC was at the mercy of its primary regulator and with so many legal bills constantly hanging over its head, BAC was handcuffed. With that nonsense out of the way, I believe BAC will begin in 2015 to return capital in a big way. The dividend has already been raised and I believe it will be raised substantially again next year - possibly another 20 cents - and I also think BAC will ask for a large buyback as well. I'm hoping for something in the $6 billion range but it may be lower than that given that BAC is just now getting its footing.

Either way the combination of a stronger chart, improving fundamentals and earnings power and the high likelihood that returns of capital will skyrocket next year mean that BAC is a bargain. While not an income stock by any means just yet, BAC will get there and the combination of a respectable dividend and a strong buyback should get more investors interested in the stock. I couldn't be happier with where BAC is right now and I think we'll see it in the $20s in 2015.

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.