If you invest in bank stocks, and Bank of America (NYSE: BAC) in particular, then there are three things you should keep your eyes on in terms of its performance.
These three metrics cut to the heart of a successful investment in bank stocks, covering a bank's profitability, growth in book value, and dividend yield.
There are two levers that most directly impact the return on investment when it comes to bank stocks: how much the shares appreciate in price and how much they pay out via dividends.
But these two things share a third thing in common: profitability. The more profitable a bank is, the more earnings it retains, and the more its book value (and thus share price) is likely to appreciate. Similarly, the more a bank earns, the more it can distribute to shareholders.
Profitability in the bank industry is measured by return on assets and/or return on equity. Return on assets is calculated by dividing a bank's annual earnings (numerator) by its total assets (denominator). The numerator is the same when calculating return on equity, but the denominator is instead, as the name implies, shareholders' equity.
Generally speaking, I think a bank's return on assets is the best of the two, because it eliminates the impact of leverage on profitability. Holding all else equal, a bank that can earn the most without relying too heavily on leverage, which increases risk, is a better bank stock to own.
Bank of America's return on assets in the latest quarter was 0.93%. That's just below the bank's stated goal of earning a 1% return on assets, which also happens to be a common benchmark in the industry that most banks strive to exceed.
2. Growth in book value per share
The second metric is based on a bank's book value per share. This is calculated by dividing a bank's shareholders' equity by its outstanding share count.
Book value is important because this is how bank stocks tend to be valued. The shares of banks that generate superior profitability, tend to trade for a premium to book value per share. Alternatively, shares of banks with inferior profitability, tend to trade for a discount to book value per share.
It accordingly follows that the faster a bank's book value per share grows, the faster its share price is likely to grow as well. This isn't one for one, but it's a good enough general rule that one can use it to conceptualize why certain banks stocks have outperformed others over time and are likely to continue doing so in the future.
In Bank of America's case, its book value per share grew in the latest quarter by 4.9%. That's not amazingly fast by any stretch of the imagination. But it's headed in the right direction. And when combined with Bank of America's growing dividend, it should help to give the bank's shareholders a respectable long-term return.
3. Dividend yield
The final metric gauges how big a bank's dividend is compared to how much you have to pay for its stock. This is the dividend yield. It's calculated by dividing a bank's annualized payout by its current share price.
So, in Bank of America's case, over the next 12 months it is expected to pay out $0.48 per share, after raising its dividend following this year's stress test. Meanwhile, its shares are currently priced at $23.84 a share. If you divide those out, you get a dividend yield of 2%.
This isn't the highest dividend yield in Bank of America's peer group -- i.e., banks on the KBW Bank Index. But it's also not the lowest.
The important thing for investors to remember is that you want to add a bank's dividend yield to its rate of growth in book value, as the two together will offer the best insight into what the future returns of a bank stock will be.
And in Bank of America's case, that comes out to right around 7% a year. That won't make you rich overnight and, of course, anything can happen to any company at any time, but that seems to me to be a very respectable and sustainable return.
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