With Bank of America (BAC) getting some bad press today (click here to read about the new legal issues coming to the forefront), we thought it might be helpful to walk through how the firm stacks up against peers across a variety of metrics. For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation (or residual income valuation in the case of banking firms), relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Bank of America posts a VBI score of 7 (was 4), reflecting its fairly valued nature on the basis of our residual-income valuation model, its attractive valuation on the basis of its price-to-tangible-book ratio versus peers, and its bullish technicals. As is consistent with our stock-selection methodology, we prefer firms that have scores of 9 and 10, as it has been shown that a cohort of stocks with both attractive value and momentum qualities have great potential for outperformance. We make available for financial advisors our white paper outlining this conclusion here.
Our Report on Bank of America
We're not too thrilled about owning any bank stock, and Bank of America is no exception. Though the firm's Tier I capital ratio seems sufficient, its returns have been terrible over the past five years. We also don't find its valuation all that attractive on the basis of our residual income model. Its current tangible book per share versus our fair value estimate indicates that we don't expect much value creation in coming periods, providing further support for our ValueCreation rating of POOR for the bank.
We use a residual income model to derive our fair value estimates for banking firms. A bank's current tangible book value is first grossed up or down by the discounted value of its forecast annual net income less an annual capital charge (10% of tangible book value) during the next two years. We then use normalized earnings less the annual capital charge in our perpetuity function (discounted to present). The firm's fair value is then compared to its stock price. For banks, we use a standard 20% margin of safety to determine both the upper and lower bounds of our fair value range. If a bank is trading below (above) the lower bound of our fair value range, we consider it undervalued (overvalued). If its stock price falls within our fair value range, we think its shares are fairly valued. In Bank of America's case, we think the shares are worth $9 each, and the lower end of our fair value estimate range is $7 per share. By extension, we view Bank of America shares as fairly valued on the basis of our residual income model. Its shares aren't trading below the lower end of our fair value range.
We use price/tangible book as the primary measure to determine whether one bank is more attractive than another on a relative value basis. For banks in the top tier of our relative-value ranking, they receive a rating of attractive. Banks at the bottom tier receive an unattractive rating. Banks in the mid-tier receive a neutral rating. All banks receive a ValueRisk rating of high due to their inherent dependence on the capital markets. Bank of America is near the top of our relative-value ranking and earns a relative-value rating of attractive.
We rank banks by their respective return on tangible common equity (OTC:ROTE), which we define as diluted earnings per share divided by tangible book value per share. Firms that score in the top tier of our bank universe on this measure in their most recently reported fiscal year receive a ValueCreation™ rating of excellent, while firms that score in the mid tier of our bank universe receive a ValueCreation™ rating of good. Firms that score in the bottom tier but still have a positive ROTE receive a poor rating, while firms with a negative ROTE receive a very poor ValueCreation™ rating. Bank of America receives a poor rating on this measure as its returns are bottom-tier and fall below our 10% threshold we use for a bank's cost of equity.
Our bank ValueTrend™ rating compares the company's five-year average ROTE with its most recently reported fiscal year ROTE. If a bank's most recently reported ROTE is greater than its five-year average, it receives a ValueTrend™ rating of positive. If a bank's most recently reported ROTE is less than its five-year average, it receives a ValueTrend™ rating of negative. Bank of America's measure is negative.
The Tier I capital ratio is a measure of the firm's Tier I capital (consisting largely of shareholders' equity and disclosed reserves) divided by the firm's risk-weighted assets. We rank banking firms based on this measure to show which banks have the greatest capital strength after considering the riskiness of their underlying assets. Banks in the top tier earn a capital strength rating of excellent, while banks that do not fall in the top tier but still have a Tier I ratio above 10% earn a capital strength rating of good. Banks that have a Tier I ratio lower than 10% earn a rating of poor on our scale. This is a relative measure with absolute threshold considerations. Bank of America earns a capital strength rating of good.
All Things Considered
We think the application of our Valuentum Buying Index stock-selection methodology is key to uncovering the most attractive banking stocks at the best to time consider buying. Even though Bank of America's score has improved since we last commented on the firm, we won't be adding it to our Best Ideas portfolio anytime soon. We demand a score higher than 8 for consideration.