A 51% Annualized Return With BAC

| About: Bank of (BAC)

On October 17, 2012 Bank of America (NYSE:BAC) reported a solid quarter. A recent article by Tim Travis highlighted many of the improving fundamentals at BAC.

From a fundamental basis, I'd like to review several important metrics from its 3Q 2012 Earnings presentation. Tangible Book Value (TGV) is currently $13.48 per share, up $0.26/share from Q2 and up from $8.65 in 3Q 2011 (table page 6, and Chart page 7). Tier 1 common capital ratio is currently 11.41%, up 276 bps from Q3 2011 (table page 6). These two metrics provide a good sense of BAC's fundamental value, and also its capital "cushion" when times get rough.

As Tim correctly pointed out, BAC seems to have come to grips with a "worst case" scenario for potential credit/loan losses (6 billion more than they have set aside). There will be lawsuits for years to come, however, much of this uncertainty is already priced in to the stock. As the worst case scenarios are moved off the table, I think BAC will near normalized valuations.

What is a normalized valuation? With reasonable assumptions we can project "normalized" earnings of $1.50 to $2.20 per year; this can be done by projecting return on tangible equity or return on average assets. Additionally, common stock appreciation should be realized when BAC is allowed to start paying a dividend or repurchasing stock.

From a historical perspective, banks pre-crisis traded at an average of 3.2x TBV (1). For BAC, this would be $43.136 (13.48 x 3.2). Let's dismiss this lofty value for a moment, under the assumption that in this brave new world, the new rules and regulations will prevent banks from earning what they did pre-crisis. The average US bank stock is currently trading for approximately 1.4x TBV. At this multiple, BAC would be $18.87 (1). Either from an EPS perspective or as a multiple of TBV, it's reasonable to see BAC hitting a $13.5 to $18.9 value (P/TBV of 1 to 1.4, coupled with a reasonable PE).

Now that we have realized this hidden value, let's give the market some time to catch up, shall we? We don't want to initiate an options trade which matures in several months. Perhaps an option trade with expiration of January 2015? That gives the market more than 2 full years, and also provides more time for BAC fundamentals to continue improving.

Trade (prices as of 10/28/2012), with options prices at the mid-point of bid-ask spread.

  • BAC $9.12
  • BAC January 2015 $7 Call at $3.23 (Buy to open); these have $1.11 of premium to intrinsic value. This is determined by the current stock price minus the strike price ($9.12 - $7) which gives us the intrinsic value ($2.12). Anything left is premium ($3.23 - $2.12).
  • Let's sell the BAC January 2015 $12 Call $1.13 (sell to open). This will recapture all the premium, and a couple cents extra.

This effectively gives us a pure play for upside on BAC, with a $5 call spread (the January 2015 $7 to $12 call spread), which we are buying for $3.23 minus $1.13, or $2.20 net.

This is a very conservative spread that allows us to profit from upside in BAC at a significantly greater rate than if we just bought the stock. If BAC is at or greater than $12 in January 2015, our position will increase from $2.20 to $5 (127% upside versus 31% for the stock at a BAC value of $12). Yet, the breakeven price in BAC is $9.20; this means that we break even if BAC appreciates only $0.08 or less than 1% from now through January 2015.

I chose the $12 calls because that places BAC at only 90% of its current TBV. This means that with further appreciation in TBV this should be a very attainable price by January 2015. Yet, the options trade yields an annualized return of 51% (127% total).

For the more risky trader, you could buy the January 2015 $7 call now, and sell the higher call at a later date to take advantage of interval price appreciation. Or, you could sell the January 2015 $15 call and collect less premium, but give yourself an $8 spread at maximum.

Disclosure: I am 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.