Despite the decent returns realized by anyone who was a buyer of Bank of America (BAC) a decade ago, the share price has actually been disappointing to many. I clearly recall buying Bank of America in the single-digits per share, knowing that as they worked through the bad loans from the failed Countrywide purchase, their underlying earnings power of $2.00 per share would shine through. Today, with earnings per share closer to $3.00, those problem loans are a distant memory. Bank of America is earning record profits and its stock has tried to break out several times, yet it continues to trade poorly, at just about 9 times earnings.
So when Bank of America released its CCAR results and its updated capital allocation plan this summer, announcing a stunning $30.9 billion of buybacks to be executed this year (12% of all shares), I suspected that it was only a matter of time before the stock broke out to new 52 week highs. That break out failed yet again last month as the escalating trade war took down nearly all stocks, and as the Federal Reserve began cutting interest rates.
However, investors should not worry here. Bank of America shares are one of the most compelling bargains in the market today. Its shares are already priced as if we are going into a recession, and the stunning size of Bank of America’s buyback practically guarantees that the stock will generate strong returns for shareholders eventually. It’s time investors get the bad taste of bank stocks out of their mouths, because the future is going to be a whole lot better.
Bank of America is already priced for a negative growth future
Valuing a stock is not very hard. In fact, there are several different time tested valuation methods that investors can always rely on to determine intrinsic value. Book value is one. When a highly profitable company trades at or below its own book value, especially when that company is steadily growing its book value, it is almost always a recipe for long-term success.
Discounted cash flow/earnings analysis is another valuation method that has stood the test of time. Essentially, this method calculates the cumulative value of all the money a company is expected to earn over its life, and then discounts it to compensate the investor for not only the time value of money, but also for the possibility that they are wrong.
Bank of America stands out in either method. A quick look at the company’s 10Q shows us that the stock has a per share book value of $26.41. Not far from the actual current stock price of $26.64. It’s also noteworthy that Bank of America’s book value has grown from $21 to $26.41 over the past five years. This growth has come from a combination of retained earnings and a decreasing share count.
Trading for book value really just tells us the market is awarding the stock no premium to what the company would be liquidated for. For a brand like Bank of America, I find it impossible to believe that the branch network, the systems in place, the bankers, the connections to the global capital markets, Merrill Lynch, US Trust, and everything else has no value beyond what you could get if you shut everything down. Frankly, that idea is laughable, so using book value as a measurement tool, we quickly realize that Bank of America is undervalued.
With discounted earnings analysis, the present value of estimated future earnings tell us the current intrinsic value of the shares. This method is how we know that the stock is pricing in a no growth future. Using a discounting calculator such as the one found by clicking here we can estimate intrinsic value for Bank of America shares. If we use $2.90 per share as our base earnings (the mid-point between 2019 & 2020 eps), and a 10% discount rate, we see that even with zero growth in earnings ever again, Bank of America shares should trade for more than they currently trade for. Add in a little growth, and intrinsic value rises significantly. For example, just 3% growth brings intrinsic value into the $40s per share. 5% growth brings intrinsic value to about $60 per share.
I encourage all readers to play around with this calculator. Not only look at Bank of America, but look at the high-flying popular companies as well. Once you do, it becomes very clear that Bank of America is really, really cheap.
Putting $30.9 billion into perspective
$30.9 billion dollars. That’s how much stock Bank of America is planning to repurchase over the 12 month period beginning July 1. That’s $7.7 billion per quarter, and $2.5 billion per month. If you consider that there are about 21 trading days per month, that means Bank of America is spending roughly $122 million each trading day buying their stock. At current prices, that means the company is buying about 4.5 million shares each day. If share prices stay roughly flat with where they are today, Bank of America will repurchase about 1.1 billion shares, or almost 12% of their share count between now and June 30, 2020.
Now, recall the discounting calculator. We already know that just 5% growth brings intrinsic value up to $60 per share, so if Bank of America continues to repurchase its shares at the blistering rate of 12% per year, the intrinsic value of the stock rises into the triple-digits. Now, to be fair, I am not in any way suggesting that Bank of America is going into the triple-digits per share anytime soon. What I do think will happen is that the market will eventually wake up and begin pricing the stock "appropriately" i.e., A lot higher.
A realistic look at Bank of America’s future dividend
One of the side effects of the Federal Reserve only allowing big banks to pay out 30% of their earnings as dividends is that it pushes the really large banks such as Bank of America to divert the remaining 70% of their earnings into buybacks. As Bank of America buys in roughly 1.1 billion shares over the course of this year, it will no longer have to pay dividends on those shares. The cash savings on those purchases amount to nearly $800 million per year.
By buying back so much stock, Bank of America can actually increase its dividend per share in perpetuity without ever earning more total profit. Of course, as GDP grows, Bank of America should grow profits too, and the combination of these two factors set up dividend investors for a rosy future.
If Bank of America increases its dividend by 15% annually for the next ten years, their per share dividend is likely to reach about $2.90. This means that investors who buy today could realize over 10% of their purchase price in cash annually by that time. This will no doubt drive Bank of America’s share price higher, most likely in line with the dividend increases themselves.
So whether from dividends, or from buybacks, Bank of America’s capital returns set up shareholders for a bright future, one that is not at all being priced into the shares at the moment.
So what is Wall Street afraid of? (The psychology of investing)
I said in an earlier paragraph that valuing a stock is not that hard. It really isn’t. I’ve just laid out several very real reasons that Bank of America is undervalued and should trade a lot higher going forward. But valuing a stock is not the hard part. The psychology of investing is. Humans are illogical and irrational when it comes to money and investing. They obsess over short-term results and discard long-term opportunity. They fire fund managers after a bad quarter. As a result, the average fund manager churns their portfolio endlessly, selling stocks that aren’t going up and buying ones that are.
Here’s why Bank of America isn’t going up. Because Wall Street hates it. They hate it because the Fed is expected to continue cutting interest rates and that will hurt Bank of America’s net interest income. Never mind the balance sheet growth that acts an offset to this, and never mind the buybacks effect on earnings per share that will overwhelm it. No, Wall Street traders are like trained seals. If the Fed is raising interest rates, they buy asset sensitive banks. If the Fed is cutting interest rates, they sell. Period. No amount of logic and reason will matter in the immediate future.
They also hate Bank of America because of the perceived risk of a recession. Never mind the CCAR results that show how Bank of America can withstand massive shocks to the economy and still be okay. For example, the 2019 CCAR adverse scenario was a hypothetical 10% unemployment rate, a 25% decline in home prices, 35% declines in commercial real estate values, a stock market that declines by 50%, the VIX rising to 70, and a full blown global recession. In this hypothetical scenario, Bank of America stress tested its assets and still managed to be overcapitalized.
And quite frankly, Wall Street hates Bank of America because, well, they never really stopped hating it from 2008 and 2009. So many investors were burned by the $100 billion of losses stemming from the Countrywide acquisition and the Great Recession, and they’ve never really warmed back up to Bank of America. This is what I mean when I say that Wall Street has a bad taste in its mouth. The perverse psychology that comes from how humans think about making and losing money is likely still putting a drag on Bank of America’s share price. Valuing a stock is easy. Dealing with the psychology of the market is the difficult part.
Eventually the market is going to get this right
The market is little more than a popularity contest in the near-term. Right now, Bank of America is just not popular. As long as the Fed is expected to cut interest rates, it probably will stay that way. It also doesn’t help that Bank of America is about as liquid of a stock as you’ll ever find. With 50 million shares trading on an average day, everyone thinks that they can just buy as much as they want when the time comes. As long as that’s the mentality, BAC will probably just move with the market.
But make no mistake, the turn will come one day. Bank of America simply cannot buy 12% of its share count each year and never see its share price rise, especially when Warren Buffett owns 10% of the shares to begin with. You also can’t endlessly trade below book value when your book value is steadily rising. You cannot raise your dividend by 15% each year and not eventually see a corresponding increase in share price. And you cannot punish a stock forever for the bad decision that was the purchase of Countrywide over a decade ago. Eventually Wall Street will have to get the bad taste out of its mouth. And when it does, Bank of America is going to trade a lot higher.
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.