Bank of America's CEO Just Answered an Important Riddle for Shareholders

By John Maxfield Markets Fool.com

By one fundamental measure of performance -- net income -- Bank of America (NYSE: BAC) had its second best year ever in 2016, with earnings of $18 billion. But by another important metric -- earnings per share -- the North Carolina-based bank's performance last year was less sanguine, down two-thirds from a decade ago.

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These two data points don't seem to make sense. After all, a company's earnings per share is calculated by dividing its net income by its outstanding shares of common stock. If Bank of America's net income last year was one of its best in history, then shouldn't its earnings per share be among its top performances, too?

Theoretically, the answer to this question is "yes." In Bank of America's case, however, the answer is obviously "no."

Data source: YCharts.com. Chart by author.

How should one go about reconciling this contradiction? As Bank of America Chairman and CEO Brian Moynihan explained in his latest annual letter to shareholders, which is at the beginning of the bank's 2016 annual report here, the answer has to do with the bank's outstanding share count:

In 2006, we earned the most in our history ($21 billion). We had 4.6 billion shares outstanding, meaning our diluted earnings per share was $4.58. We also paid a common stock dividend of $2.12 per share, or 46 percent of our earnings. Now, compare this to our 2016 results: earnings were $18 billion, but because we had more than twice as many shares outstanding, our EPS was $1.50 per diluted share, and our common stock dividend was $0.25 per share, or 17 percent of earnings.

The biggest difference between the two periods is the increase in common shares and a reduction in the dividend. Both were necessary to stabilize the company after the worst economic crisis since the Great Depression, and now that our company is stronger, we are focused on reducing the dilution and increasing the dividend.

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What Moynihan is referring to here is that Bank of America's share count exploded in the wake of the financial crisis, going from 4.6 billion shares of common stock outstanding all the way up to 11.6 billion shares, after factoring in the impact of options to purchase Bank of America stock like those held by Warren Buffett's Berkshire Hathaway.

Image source: The Motley Fool.

The explosion traces its roots to three sources. First, Bank of America had to raise capital to offset the nearly $200 billion worth of losses it suffered during and after the crisis. Second, it issued stock to purchase Merrill Lynch in 2009 (though the deal was announced in 2008). And third, it issued stock to repay the government's injection of capital into Bank of America under the crisis-era TARP program.

The net result is that Bank of America's earnings are now spread among more than twice as many shares as a decade ago, which solves the riddle of why its performance last year looks so much better if you focus on net income as opposed to earnings per share.

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John Maxfield owns shares of Bank of America. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.