The Best-Case Scenario for Bank of America's Stock

By Markets Fool.com

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Given the events of the past decade, it's my opinion that Bank of America will continue to underperform its better-heeled peers for years, if not decades, to come.

But what if I'm wrong? What if people who are bullish on Bank of America's stock are correct to think that its problems are temporary and that it will soon put what's left of the financial crisis in the rearview mirror once and for all?

While I don't believe this is likely -- after all, Warren Buffett once observed that "turnarounds seldom turn" -- it's worth considering how much investors in the nation's second-biggest bank by assets stand to gain if Bank of America can stage a comeback.

With this in mind, I did some calculations, and here's what I came up with: If Bank of America could generate an average annual return of between 10% and 15% of its shareholders' equity, excluding preferred stock, then a shareholder who invested $10,000 in Bank of America stock and automatically reinvested their dividends in more stock could end up, after 30 years, with between $325,000 and $1.3 million.

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This is a rough estimate that rests on a number of pivotal assumptions -- though it's worth noting that all of the assumptions are consistent with industrywide practices.

I assume, for instance, that the value of Bank of America's stock gradually improves from 0.77 times book value today to 1.5 times book value 30 years from now. I also assume that Bank of America allocates its net income evenly, as most banks strive to do, between dividends, share buybacks, and retained earnings. Moreover, I assume that the bank repurchases its stock at quarterly intervals corresponding to its gradually escalating valuation.

Last but not least, by assuming that Bank of America can generate a double-digit average return on equity, I'm implicitly assuming that it won't suffer significant losses in a future crisis. This is probably the most unrealistic assumption of all; the Federal Reserve, for instance, projects that Bank of America would lose $37.3 billion if the economy experienced another severely adverse economic scenario akin to the financial crisis of 2008-2009 -- but it goes hand in hand with the thesis that the bank is merely suffering a temporary setback.

Ultimately, for this projection to come to fruition, Bank of America must do two things. First, it must drive down its bloated expense base. In the most recent quarter, its efficiency ratio (operating costs divided by net revenue) was 73.3%. If it wants to generate, say, a 12% return on equity, its efficiency ratio must come down to somewhere in the neighborhood of 60%, depending on the bank's effective tax rate and how much it sets aside for future loan losses on a quarterly basis.

And second, it must increase its annualized net revenue to, by my estimate, upwards of 4.75% of its average total assets. Right now, that figure is 3.96%. In the most recent quarter, that would amount to $4.25 billion more in quarterly revenue, an increase of 20%.

Improvements of this magnitude are significant, which is why I'm skeptical about Bank of America's ability to outperform the bank industry and the broader market over the long term. But if I'm wrong and Bank of America bulls are right, then current shareholders in the Charlotte, N.C.-based bank are almost certain to get rich by betting that its best days are yet to come.

The article The Best-Case Scenario for Bank of America's Stock originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. 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.