An Excess Return Model Of Bank Of America

| About: Bank of (BAC)

Summary

DCF models cannot accurately determine the value of financial institutions.

An excess return model provides a better representation of Bank of America's fair value.

Based on this model, Bank of America has 27% upside potential.

Although many, including myself, are fans of valuing companies using the coveted discounted cash flow model, it remains difficult to evaluate financial services firms based on this method. Two main inputs within the DCF method present a problem for investors: capital expenditures and working capital. Financial institutions invest mainly in human capital and their brand, rather than physical investments such as manufacturing plants or new equipment. Many of their capital expenditures are classified as operating expenses. This results in relatively few capital expenditures being shown on the cash flow statement (likewise for depreciation and amortization). In addition, if we use the definition of working capital as the difference between current assets and current liabilities, much of a bank's balance sheet is represented, resulting in a large and volatile computation that has no relationship with future growth.

In the case of Bank of America (NYSE:BAC), it seems much more appropriate to use an excess return model to determine the true value of the stock. In a nutshell, this model determines the value of equity by summing the current value of equity capital invested and the present value of expected excess returns from the current equity and future investments. The former is simple to determine; it is merely the shareholder's equity on the balance sheet. However, the latter is more difficult to compute. It relies on forecasting the future return on equity and cost of equity.

Return on Equity (ROE)

Based on current market conditions and Bank of America's historical return on equity, it seems likely that the company can manage a 10-12% ROE. Keep in mind that in the years prior to the financial crisis, Bank of America was averaging 15-16% ROE. In addition, its competitors currently have approximately 10-12% ROE. Looking forward and considering the changes in the regulatory environment, 10% ROE for Bank of America seems justifiable. The firm may never be able to return to the glory days of 16% ROE, but I am remain confident that it can earn a low double digit ROE in the future. However, I expect the ROE to ramp up by 50 basis points in the first year, and 100 basis points each year thereafter from the current 7% to 10%.

Cost of Equity (NYSE:COE)

The cost of equity can be determined using the capital asset pricing model (CAPM). It states:

Cost of Equity = Risk free rate of return + Beta × (market rate of return - risk free rate of return)

The risk free rate of return is approximately 3% (30-year US Treasury yield is currently 2.85%). Assuming a beta of 1.0 (similar to other companies in the industry) and a market rate of return of 7%, the cost of equity is:

COE = 3% + 1.0(7% - 3%) = 7%

7% is an appropriate COE for Bank of America given its risk compared to the market and the risk free rate of return. I anticipate the COE this year to be lower (6%), but it will ramp up by 50 basis points each year until it reaches 7%.

Modelling Excess Returns

Now that we have our ROE and COE, we can quickly compute the present value of excess returns.

  2015 2016 2017 2018 2019
Net Income $ 15,825.62 $ 17,996.78 $ 20,429.56 $ 23,164.40 $ 26,246.42
Equity Cost $ 14,608.26 $ 16,711.30 $ 19,067.59 $ 20,268.85 $ 21,614.70
Excess Equity Return $ 1,217.36 $ 1,285.48 $ 1,361.97 $ 2,895.55 $ 4,631.72
Cumulated Cost of Equity 1.0600 1.1289 1.2079 1.2925 1.3830
Present Value $ 1,148.45 $ 1,138.71 $ 1,127.53 $ 2,240.31 $ 3,349.16
           
Beginning BV of Equity $ 243,471.00 $ 257,096.85 $ 272,394.12 $ 289,554.95 $ 308,781.40
Cost of Equity 6.00% 6.50% 7.00% 7.00% 7.00%
Equity Cost $ 14,608.26 $ 16,711.30 $ 19,067.59 $ 20,268.85 $ 21,614.70
           
Return on Equity 6.50% 7.00% 7.50% 8.00% 8.50%
Net Income $ 15,825.62 $ 17,996.78 $ 20,429.56 $ 23,164.40 $ 26,246.42
Dividend Payout Ratio 13.90% 15.00% 16.00% 17.00% 18.00%
Dividends Paid $ 2,199.76 $ 2,699.52 $ 3,268.73 $ 3,937.95 $ 4,724.36
Retained Earnings $ 13,625.85 $ 15,297.26 $ 17,160.83 $ 19,226.45 $ 21,522.06

Note: All figures are in millions of USD.

As you can see, I also assumed an increase in the dividend payout ratio as the firm returns more cash to shareholders. Based on these calculations, the current value per share can be determined. Note: I assumed that the terminal value of equity is 0 (i.e., the company stops growing after year 5).

BV of Equity $ 243,471.00
PV of Equity Excess Returns $ 9,004.15
PV of Terminal Value of Excess Returns $ -
Value of Equity $ 252,475.15
Number of Shares 11,238
Value per Share $ 22.47

Conclusion

Based on the excess returns method for pricing financial services firms, Bank of America's fair value per share is $22.47, representing more than 27% upside from the current price of $17.66. Coupled with a 1.14% dividend yield that is sure to grow substantially over the coming years, Bank of America deserves a spot in your portfolio. In addition, it is by far one of the best ways to capitalize on the upcoming rate hike leading to greater net interest margins for banks.

Source: Bank of America quarterly results, Yahoo Finance, "Valuing Financial Services Firms"

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BAC over the next 72 hours.

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.

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