Plenty of people have debated how we should value financial stocks in a post-housing market collapse. The valuations on many of these companies have dropped well into the single digits as management continues to work non-performing loans off the books. A shining example of this would be one of the biggest banks of them all - Bank of America (BAC).
Three years ago as the government was conducting a series of stress tests to determine how well banks were positioned in various economic environments, Bank of America ended up being the big loser. It was determined that the company needed to raise an additional $33.9 billion in capital just to be considered adequately funded - a number that was almost as much as all other banks being stress tested needed to raise COMBINED.
The stock plummeted from a high of almost $60 a share all the way to under $4. The company ended up adding about $25 billion in TARP funds to their books and they've been struggling to clean up their balance sheet ever since. After a brief rally, the stock dropped again to around $5 at the end of last year on worries that the bank would need to raise additional capital to cover anticipated losses in their residential real estate and home equity portfolios.
The stock price has experienced a bit of a renaissance this year rising to its current price of around $10. That would be a solid performance for the stock this year but a look at the fundamentals indicates that this stock could be going higher still and you should be buying before it does.
As part of the deal for accepting TARP funds, Bank of America was required to adhere to certain restrictions such as meeting specific capital ratio targets and limiting the amount of income they could pay out to shareholders in the form of dividends. B of A slashed its dividend to a penny per share back in 2008 and that's where it's stood ever since but that may be about to change.
Earlier this year, the Federal Reserve conducted the latest round of stress tests using a more severe recession scenario that included high unemployment and low to negative GDP growth. Bank of America along with most of the other financials being tested passed - the notable exception being Citigroup (C) - and their stock prices soared.
With the test results in hand, the Fed began loosening some of the restrictions that were placed on the banks that accepted TARP. JP Morgan (JPM) - a company that issued new shares in order to raise the capital mandated by the original stress tests - announced plans to buy back $15 billion of its own stock. US Bank (USB) announced that they're buying back their own shares in addition to raising its quarterly dividend from $0.13 to $0.20. Wells Fargo (WFC) similarly increased its dividend from $0.12 to $0.22.
Bank of America hasn't made a move to buy back its stock or raise its dividend yet but it may be about to. In their 3rd quarter earnings report, the company stated that its provision for credit losses was down 48% when compared to last year. This means that the overall health of the balance sheet has improved - a notion that is further cemented by its success in the latest stress tests. The bank continues to generate billions in free cash flow and that number will be augmented by several cost cutting measures undertaken by the company in the past year.
Considering the improved fundamentals for the company, the cash that the bank currently has on hand and the results of the latest government stress tests coupled with the fact that there have been multiple precedents on this front recently, I believe it's just a matter of time before Bank of America states that it is increasing its dividend and, quite possibly, announcing a stock buyback.
Prior to the housing market collapse, Bank of America sported one of the juicier yields among the financials. Management won't take it back to its peak levels right off the bat but matching the 2.5% yield of Wells Fargo, JP Morgan and US Bank seems like a reasonable starting point.
It's also reasonable to assume that the stock price could see a jolt with a dividend announcement as well. The stocks prices of Wells Fargo and JP Morgan (and the financials as a whole) have performed well this year and that's reflective of the belief that the sector is successfully working off the excesses of the mortgage crisis and that better times are resuming. Reinstating the dividend will show Bank of America investors that several Fed hurdles have been cleared and the financial health of the bank is returning.
In this scenario, there's no reason to think that long-suffering shareholders of Bank of America won't be rewarded.