Bank of America Is Cheap, but That Doesn't Mean You Should Buy

By Markets Fool.com


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No matter how you slice it, Bank of America's stock is flat-out cheap right now.

Price to book value? B of A trades at roughly 60% the level of JPMorgan Chaseand 40% of Wells Fargo. On a forward-looking price-to-earnings basis, B of A's 8.9 times is 22% below Wells and 15% less than JPMorgan. You'll find similar results with price to tangible book value and just about every other valuation metric you can think of.

But a cheap price doesn't necessarily mean that you should buy a stock, and even at this big discount, I think Bank of America stock remains a risky bet.

The argument for Bank of America stock
Since the financial crisis, Bank of America has undertaken a massive transformation. The bank has simplified its business model, cut costs, shrunk and strengthened its balance sheet, and reduced risk across the board. It did all this despite facing billions upon billions of dollars in fines, penalties, and liabilities for a whole host of bad behaviors in the lead-up to the financial crisis. Fellow Fool John Maxfield has kept a running tally of B of A's legal fines and settlements, and, at last count, the total was upwards of $100 billion. It's hard to understate how significant the end of those liabilities are for the bank.

Last year though, a major court decision in New York state ruled that the statute of limitations had legally expired on a significant portion of those liabilities, specifically those having to do with problems with the representations and warranties tied to packages of mortgage backed securities. In the 2015 second quarter, B of A was able to release $7.6 billion in legal reserves as a result of this development. Not exactly peanuts.

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That major success came on the heels of the completion of the bank's cost-cutting initiative in the fourth quarter of 2015, called Project New BAC. That initiative began in 2011 and will save the bank $8 billion in annual operating costs going forward.

The bullish theory goes that after seven-plus years of struggle, the bank can finally get back to doing business instead of managing problems from the rear view mirror. The tough job of cutting costs is complete, and the shadow of the financial crisis has at long last lifted.

That sounds great, and it does make some sense. The problem is that the numbers the bank has put up thus far have been pretty disappointing.

Where are the profits?
Using data provided by S&P Capital IQ, Bank of America's problem comes into focus. Despite all the hard work transforming the bank from 2008 to today, the results still lag the better performing megabanks by a considerable margin.

Bank

Return on Assets (TTM)

Return on Equity (TTM)

Dividend Yield (TTM)

Efficiency Ratio (Q4 2015)

Bank of America

0.7%

5.2%

1.45%

70.2%

JPMorgan Chase

1%

8.8%

2.84%

60%

Wells Fargo

1.3%

11.9%

2.97%

57.4%

Industry Average*

1%

9.1%

2.8%

58.6%

*Efficiency ratio, ROA, and ROE for U.S. banks with more than $10 billion in total assets, sourced from the FDIC's fourth quarter 2015 Quarterly Banking Profile. Dividend yield from sample of 59 large banks; data from S&P Capital IQ.

Would you expect return on assets to trail comparable banks and the industry average by 30-plus basis points at a company that has recently cut $8 billion in annual expenses and released $7.6 billion in legal reserves?

Or would you predict that company to trail its peers and industry by almost two times in return on equity? In light of these major victories, wouldn't you expect the numbers to look a little rosier?

The bank's metrics related to credit quality, balance sheet capital, and revenue mix are all in line with Wells, JPMorgan, and the industry. Even still, Bank of America hasn't been able to translate its revenues into profits at anywhere near the same rate as other bank stocks. That shortcoming is driving the bank's lower dividend yield as well as its lower valuation in the stock market.

Bank of America stock isn't cheap by accident. It's cheap because the bank isn't producing the same profits as other comparable bank stock options.

What needs to happen next
Bank of America's efficiency ratio is prescriptive of what the bank must do next. The efficiency ratio is a measure of how much a bank must spend to generate its net revenue. A lower efficiency ratio is better, indicating that a bank has a lower cost structure relative to its revenue.

With an efficiency ratio of 70% for the fourth quarter, the path forward for the bank must start with further improvements to its cost structure without sacrificing long-term investments to drive revenue growth. The best of the large U.S. banks have been able to maintain an efficiency ratio at or below 60% in the current interest-rate environment. Until Bank of America makes a meaningful improvement toward that level, investors should expect the bank's profits and valuation to continue to trail its peers.

Bank of America is a huge bank, and it will certainly take more than just a few quarters to fully see the stock's potential without the burden of its legal liabilities. In my view, however, the bank is off to a disappointing start. Investors looking for a turnaround story may be better served to wait and watch for now.

The article Bank of America Is Cheap, but That Doesn't Mean You Should Buy originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short May 2016 $52 puts on Wells Fargo. The Motley Fool recommends 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.