In this article I will highlight Bank of America’s fair value growth projections over the next 10 years. The fair value is sometimes referred to as the “Graham number”, named after Benjamin Graham, the founder of value investing. According to Benjamin Graham, the fair value is the maximum price that a defensive investor should pay for a stock. The fair value is derived off a company’s earnings per share (EPS), book value and price to earnings ratio.
Currently Bank of America’s stock is trading in the 15′s, less than it net asset or book value of of $20.75 and is also trading less than its fair value or “Graham Number”. I believe the fair value will continue to grow over the next few years because of growth in EPS and book value. According to the value investors out there, the stock is trading at historic bargain prices. Bank of America (BAC) is the second largest U.S. bank by assets with $2.10 trillion in assets as of the end of 2013. It serves individual consumers, small and middle market businesses, corporations and Governments with a range of banking, investing, asset management and other financial and risk management products and services. Its provides financial services through 5 business segments: Consumer & Business Banking (CBB), Consumer Real Estate Services (CRES), Global Banking, Global Markets and Global Wealth & Investment Management (GWIM). The bank has come out stronger after the great recession of 2008. In fact the whole banking sector is at its strongest since the 1930′s. According to the latest street tests conducted by the Federal Reserve, Bank of America has sufficient capital levels to survive another great recession without taking a government bailout. However, there are several factors limiting the appreciation of its stock price in the near-term.
Factors causing Bank of America to trade below fair value:
- The bank continues to be burdened by legal disputes stemming from the financial crisis. The good news is that the big claims are finally being settled.They recently agreed to pay $9.3 billion to settle claims that it sold to Fannie Mae and Freddie Mac. Also according to a report, the bank is close to agreeing on a multibillion-dollar settlement with the Department of Justice.
- There is still a negative public view on large banks because of the financial crisis.
- Bank of America has not fully demonstrated it’s earnings potential. According to banking analyst Dick Bove, the bank has the potential to earn $2- $3 per share.
- Bank of America pays a very low dividend of 4 cents a year. It recently had to suspend a dividend increase of 16 cents per year because of an “accounting” error. The error involved structures notes the bank inherited when it bought Merrill Lunch in 2009. There is a still possibility that they will request the same dividend increase when they resubmit their capital plans within the next few weeks.
- Although the bank is above the minimum capital required by regulators, it is continuing to accumulate capital to have a cushion. As of the end of March 31, 2014, its estimated Basel 3 common equity 1 capital ratio was 11.8 %, its estimated Tier 1 Capital Ratio was at 11.8%, its Total Capital Ratio was at 14.8% and its Tier 1 leverage ratio was at 7.4 percent. These ratios reflect the adjustments due to the “accounting” error reported last week. They are all well above the minimum required by the regulators.
- Interest rates are still at all time lows. An increase in rates would increase net interest margin, a key metric for banks. Higher interest rates will make the bank more profitable.
- U.S. Economy expansion is not yet in full throttle. A rapid expansion in the U.S. and Global economy will greatly benefit Bank of America.
I am confident that all the issues will get revolved with in the next year and the bank will be on a brighter path. As buffet says, “Be fearful When Other Are Greedy and Greedy When Others Are Fearful“. Right now, everyone is fearful about Bank of America’s future. Investors need to be Greedy!
I calculated the fair value for Bank of America based on EPS, Book Value, and P/E of 13. Also, because the Federal Reserve will be very strict on capital returns to shareholders in the coming years, I included a possible maximum dividend capped at 0.30 payout ratio of EPS. I don’t think the Federal Reserve will allow generous capital returns from Large Cap banks.
There are 3 very conservative projections – a 3, 4 and 5 percent increase in both earnings per share (EPS) and Book Value every year over the next 10 years.
As you can see, patient investors will be rewarded over the long-term. The stock is a great value play amongst the Large Cap Banks at the moment.