The future looks bright for Bank of America. Image source: iStock/Thinkstock.
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When you buy a stock, you shouldn't focus on how much you think it'll be worth next week, next month, or even next year. What you should focus on instead, as I do below with Bank of America (NYSE: BAC), is how much it'll likely be worth in a decade or two, after allowing the law of compounding growth to work its magic.
The value of making projections
Getting a sense for this is both easier and harder than it seems. It's easier because it doesn't take a mathematical genius to project performance and valuation metrics forward. But it's harder because doing so only yields a rough estimate at best.
I nevertheless think it's worthwhile to go through this exercise. Seeing how quickly an investment can grow in value if left alone can only incentivize you to be a long-term investor. And that strategy is the best way for individual investors to gain an advantage over institutional investors.
On top of this, projecting a particular investment's potential return into the future can help you choose between stocks. It also forces you to think about the levers that will impact a particular stock's performance. Again, this is a rough science, but it's better than nothing.
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With respect to Bank of America, it seems reasonable to me to expect that the North Carolina-based bank will average between an 8% and 9% compound annual growth rate over the next quarter century. This means that a roughly $2,300 investment today would grow to almost $18,000 25 years from now.
Assumes a 15% return on tangible common equity, average price-to-tangible-book-value ratio of 1.5, and enrollment in a dividend reinvestment plan. Calculations by author.
My three assumptions
The first assumption I made in this projection is that Bank of America will average a 12% return on tangible common equity over the next 25 years. That's higher than Bank of America's profitability of 10.3% last quarter, but it seems reasonable when you consider the trajectory of Bank of America's earnings, the pent-up earnings power that will be realized once its debt ratings improve, and the fact that only a small increase in interest rates (the Fed Funds rate in particular) will alone put it over that mark.
Themost profitable banks, even in the inhospitable environment they're operating in right now, are able to generate returns on equity well in excess of 12%. Wells Fargo's in the latest quarter came out to 14%. U.S. Bancorp's exceeded 17%. The point being, a 12% return on tangible common equity is conservative.
My second assumption is that Bank of America's stock over the next 25 years will trade at an average multiple of 1.5 times its tangible common shareholders' equity. Right now it trades for 1.3 times tangible common equity. In the future, it'll trade for 2.0 or more times the same figure. Embedded in my assumption, then, is that these ups and downs will average out to around 1.5 times tangible book value.
Finally, I assume that Bank of America will allocate its earnings evenly between dividends, buybacks, and retained earnings. This is how banks generally strive to distribute their capital. Relatedly, I also assume that investors in its stock use a dividend reinvestment plan, or DRIP, which automatically reinvests dividends into new shares of the underlying stock.
In sum, while nearly anything can happen in the future -- a world war, a major economic depression, whatever -- these are reasonable assumptions that could just as easily underestimate Bank of America's potential as overestimate it. This is a central reason that Bank of America is my largest stock holding, as I think an 8% to 9% compound annual growth rate is a very respectable return.
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John Maxfield owns shares of Bank of America, US Bancorp, and Wells Fargo. The Motley Fool has no position in any of the stocks mentioned. 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.