Why Is Bank of America So Cheap?
Love it or hate it, Bank of America is an impressive operation to behold. To mention only the most notable figures, its balance sheet contains $2.2 trillion in assets and the lender is entrusted with more than $1 trillion worth of the nation's deposits. At the same time, however, its stock trades for a significant discount to that of its competitors. What gives?
Valuing bank stocks
When it comes to valuation, bank stocks are in a category of their own. Most equities trade for a multiple of earnings, represented by the price-to-earnings ratio. The belief is that, as owners of a company, shareholders are entitled to its profits. Profits drive return on investment. Consequently, the goal is to get the most bang for your buck in terms of earnings.
And that's exactly what the P/E ratio represents. On the low end, a ratio of five means you're paying $5 for every $1 in earnings. On the high end, a ratio of 100 means you're paying $100 for every $1 in earnings. This metric normalizes valuations both within particular industries and across the broader market.
Unless you're talking about bank stocks, that is. As opposed to a multiple of earnings, the measuring stick used here is book value per share -- and tangible book value per share more specifically, which removes intangible assets such as goodwill from the equation. This is derived by subtracting all of a bank's liabilities from its assets. It's the same thing as a bank's equity.
With this in mind, it's natural to assume that most banks would trade for no less than tangible book value. Think about it. Why would a bank trade for less than it's objectively worth?
This is where Bank of America comes in. As you can see below, along with Citigroup , it's the only other too-big-to-fail lender that trades for less than this seemingly concrete figure. Meanwhile banks like JPMorgan Chase , Wells Fargo , and particularly US Bancorp trade for healthy premiums to their valuations.
Here's the catch. While a measure like tangible book value may seem objective and concrete, the reality couldn't be further from the truth. This is because many of the asset values on a bank's balance sheet are themselves subjectively determined. There are certain complicated derivatives, for instance, that aren't traded, and thus priced, on public exchanges every day. It's left to the bank's management to figure out what these are worth.
The principal reason a bank would trade for less than its tangible equity, in turn, is because at least some analysts and investors believe that it's either overstated the value of certain assets on its balance sheet, or because it has unknown or undisclosed losses coming down the pike.
In Bank of America's case, it's a bit of both. As I discussed here, the nation's second largest lender is sitting on $136.7 billion in mortgages that are either already bad or could easily turn bad, and thus drive down the company's tangible book value. And as I discussed here, Bank of America could still be forced to pay tens of billions of dollars in legal claims for actions committed by Countrywide Financial, the mortgage originator the bank purchased in 2008.
Why I'm nevertheless bullish on B of A
The fact that a bank is trading at a discount to tangible book value isn't necessarily bad. Indeed, if anything, it presents an opportunity to buy into a stock on the cheap -- assuming, that is, you're confident the underlying operation will ultimately turn around.
And this is the reason I'm bullish on Bank of America. Does it have problems? Yes. I don't think anyone can deny that. But I'm confident it'll solve those. And when it does, both its share price and dividend payout will shoot up, rewarding investors who have the fortitude to wait.
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The article Why Is Bank of America So Cheap? originally appeared on Fool.com.John Maxfield owns shares of Bank of America. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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