Since the financial crisis, the banking sector has been consistently subjected to negative press and sentiment. And with its massive fines, challenges passing the fed stress test, and low return on equity, Bank of America (NYSE:BAC) in particular seems to be a bank that both the public and investors love to hate. However, even if the public ire is well deserved, as investors, we are looking for a good deal - where the value we receive far outweighs the price we paid. And recently, Bank of America's stock price has been pushed down low enough to account for its operational and legal trouble, but still provide a 70% upside to investors.
The market is currently valuing Bank of America at a significant discount to book value, due to the bank's low return on equity. In order to understand this, it makes sense to quickly walk through the typical approach used for valuing bank stocks.
Book value (or shareholders' equity) forms the foundation of valuations for banks because banks use mark-to-market accounting. This means their book value is a pretty accurate metric of the firm's current value, unlike firms in most other industries. Combining book value with a bank's return on equity gives you an idea of the earnings a bank should be able to generate on it's equity. Finally, an analyst would discount the annual earning estimates back to the present value using the banks cost of equity, usually estimated at 10%, in order to determine the firm's value to its shareholders.
So following this logic, "excess return", or a ROE higher than a bank's cost of equity, should cause the stock to trade above it's book value, and the opposite for banks earning less than its cost of equity. For example, Bank of America reported an ROE of 5.1% in its earnings release last week. If we divide ROE by the cost of equity (5.1% / 10%), a P/BV multiple of 0.51x could make sense. Using this framework, it is understandable why the market is currently valuing the bank at a 0.59x multiple to book value per share, given its anemic ROE.
However, the current market valuation of BAC implies that its ROE will continue to trail its cost of equity. There are two reasons I disagree with for two reasons.
First, I do not believe BAC's ROE will continue at the current level, but instead will normalize at a much higher level. Following the financial crisis, the bank has held higher provisions for loan losses, paid higher litigation expenses than normal, been subjected to almost $60B in legal settlements, fines and penalties, and retained earnings to build its capital levels in compliance with new bank regulation. And all of this has occurred during a super-low interest rate environment, compressing the firm's net interest margin and making it even harder for the bank to put those excess reserves to work at a decent rate of return.
Despite these industry-wide headwinds, most of the other banks have been able to achieve much higher ROE's, with JP Morgan and Wells Fargo both reporting ROE's well above 10%. Bank of America had more legacy issues to deal with, particularly from it's Countrywide acquisitions, and has been slower to recover in this regard. However, the bank has continued to make progress, and CEO Brian Moynihan is focused on further reducing costs and growing the business through cross-promotion of products to Bank of America's enormous customer base. There is nothing specific to Bank of America that would prevent it from closing the gap with its peers on the ROE metric.
Second, I believe the cost of equity is likely being overestimated for most large banks, including Bank of America, causing investors to undervalue the firm. Cost of equity is the rate of return investors require in exchange for the risk of investing in the equity of a company. For years, investors have used a short hand estimate of 10% for bank stocks' cost of equity, instead of using the CAPM model or some other method to calculate it. However, the higher regulatory capital requirements, ongoing stress-tests conducted by the federal reserve, and other stricter regulations of U.S. banks, have made banks significantly less levered and less risky overall than prior to the financial crisis.
And this lower risk should be reflected in a lower cost of equity for Bank of America. So, the 10% cost of equity assumption needs to be adjusted lower, given the new regulatory environment. In other words, Bank of America should probably command a 1x P/BV multiple at a lower ROE than 10%, potentially even at 7-8%, because this would match its cost of equity.
In addition to the upside potential, Bank of America's stock currently trades below its tangible book value per share, providing significant downside protection. Tangible book value is book value (or shareholders' equity) without goodwill and intangible assets. It is an extremely conservative measure of the bank's liquidation value. In other words, only in times of extreme duress should the bank trade below it's TBV per share, yet Bank of America is trading at a discount to its TBV per share of $15.62. So even if the above assumptions prove incorrect, investors should experience minimal downside risk to their investment at these prices.
In summary, the market is valuing Bank of America at a significant discount to it's book value, because of its low return on equity relative to historical norms, as well as compared to the bank's cost of capital. However, I believe the market is incorrect for two reasons. First, Bank of America's return on equity can, and likely will, normalize to a higher rate. And second, the bank's cost of capital should be lower than the historical assumption of 10% due to lower leverage and risk. Furthermore, investors have limited downside while the stock is trading at a P/TBV ratio below 1. Therefore, I think Bank of America's stock provides investors with a very attractive risk/reward investment opportunity that holds significant potential upside.
Disclosure: I am/we are long BAC.
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: This article is intended for educational purposes only, and should not be considered a professional recommendation or solicitation.