Legend has it that basketball superstar Larry Bird knew the basketball court so well that during Saturday mornings when he was in college at Indiana State, he would blindfold himself and dribble a basketball across the court for hours on end, so that he could familiarize himself with every individual pane of wood on the floor. Now picture the opposite of that level of knowledge, and we can start to have a conversation about the state of Bank of America’s (BAC) books.
If you’re a long-term shareholder of Bank of America, it has to be difficult to look at what your investment has become. Five years ago, BAC stock was trading well into the $50s, and the stock has lost 87% of its value since its high point of five years ago. Heck, Bank of America is trading 55% below its high of this year.
Of course, just because investors from five years ago got burned doesn’t necessarily mean that investors who buy in at today’s price of $7 per share will suffer from the same fate. If you’ve recently bought BAC stock, it has to be tempting to look at that $0.64 quarterly dividend payout, or $2.56 annually, and imagine what the dividend yield on cost would be if BAC could get the dividend up to pre-crisis levels. If this ever happens, investors would be achieving a $2.56/$7=36.5% yield on cost, which is certainly a recipe for outsized gains. If that ever happens, a $20,000 investment in Bank of America stock would be throwing off $7,300 in annual dividends. It could take ten years, but if it ever happens, it’s a quite impressive finish line way over the horizon for potential investors.
But for the time being, such thoughts might have to remain in fantasyland. CEO Brian Moynihan projected normalized earnings of $40-$50 billion for the bank, but then again, he’s the same guy who promised investors a dividend increase this year, which was blocked by the Fed. Not a whole lot of people are trusting Bank of America’s management these days. And as the bank has had to pay off mounting losses from the mortgage fiasco, it has had to sell off or divest over twenty-five operations or investments, recently culminating with the high-profile sale of a large block of China Construction Corp (CICHY.PK) stock. Every time Bank of America divests a unit that generates profits, that $40-$50 billion potential ought to decrease as well.
And unfortunately, it’s hard for me to take the fact that Bank of America is trading at 4/10 of book value seriously. I have no idea what Bank of America’s true book value is. If you can make that determination successfully, more power to you, and I suspect you’ll make quite a lot of money either buying the stock or shorting it. And the lingering lawsuits from Bank of America’s purchase of Countrywide is the black cloud hanging over the company. Who knows how much Bank of America will have to pay out when it’s all said and done? I’m reminded of Jose Canseco’s famous quote to ballplayers suing him for defamation, “Grab a ticket and get in line.” There’s a conga line of companies suing Bank of America, and who knows how much of future earnings will be devoted to paying off the sins of the past.
Here’s the trade-off facing potential Bank of America investors looking to buy the company at $7. If the company can get past the mortgage fiasco, it’s probably fair to conservatively estimate earnings of $25-$30 billion annually, conditional upon the company retaining its Merrill Lynch division. With about 10 billion or so shares outstanding, we’re looking at earnings of $2.50-$3.00 per share, probably about five years or so down the road. At today’s prices, that will offer you an earnings yield of 35%-43% down the road, which is quite impressive. Because the company has to meet Basel requirements, I would calculate the company paying out 30% of earnings as dividends at that point. That means we’re looking at a realistic dividend of $0.75 to $0.90 per share, which would be about an 11%-13% dividend yield on cost of today’s prices. And of course, if a healthy BAC were generating $2.50 per share in earnings, and the company were to trade at a P/E ratio of 12, we’d be looking at the stock trading around $30 per share, which would be a nice quadrupling of your initial investment.
But there is a reason why the stock is trading so low. There are three realistic possibilities that could sap BAC shareholders of the potential that lies down the road. First of all, the lawsuits are a huge unknown. What if the bleeding doesn’t stop? If Bank of America gets hit having to pay $10-$15 billion more, that could be deadly. Remember, BAC is only currently rated as a $70 billion. If it has to sell depressed assets to pay off lawsuits, its future earnings power will be considerably compromised. And if the economy doesn’t recover in the next 20-30 months, Bank of America will most likely have to sell off assets to meet capital requirements. And lastly, the greatest fear is that Bank of America will have to raise capital at these depressed prices. Let’s say Bank of America had to raise $10 billion in a stock offering. That would add almost 1.5 billion shares outstanding to the company’s records, or a 15% share dilution. Yikes. At that point, every dollar of earnings that Bank of America generated going forward would only be worth $0.85 compared with before this hypothetical capital raise.
You have to ask yourself: Do you think Bank of America will have to pay significantly more in lawsuits? Do you think the economy will continue to stay in the funk it is in today? And do you think Bank of America will have to issue a capital raise in the future? If you answer those questions yes, you should stay the heck away from this stock. But if you answer those questions no, now might offer a compelling opportunity to load up on some shares.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
