The 1 Problem With Bank of America's Profitability Target

Bank of America has come a long way since the financial crisis, but it's not yet back to where it needs to be. For Bank of America to return to its once-vaunted position atop the American financial industry, its annual net income must equate to 1% or more of its assets on a long-term, sustainable basis.

In industry parlance, this refers to Bank of America's return on assets, one of two central metrics used by investors to gauge a bank's profitability (for eight more metrics analysts use to assess bank stocks, scroll through the slideshow below). The second is return on equity, which is calculated by dividing a bank's net income by its shareholders' equity. The 1% return on assets mark matters because it translates into a roughly 10% return on equity, which is equivalent to typical bank'scost of capital. A bank that exceeds this threshold creates value, while a bank that comes up short is presumed to destroy value.

It should come as no surprise, in turn, that Bank of America has its sights set on generating a 1% return on assets.

The good news is that Bank of America is close to accomplishing this objective. In the first quarter of this year -- when expenses tend to be highest due to the payment of prior-year bonuses -- it earned 0.82% on its assets. And after adjusting for non-operating income and expenses, the figure is 0.80%.

The bad news concerns Bank of America's plan to bridge the remaining 20-basis point (0.20 percentage points) gap. According to its estimates, it will gain five basis points by reducing expenses in its legacy assets and servicing division to $500 million a quarter. This equates to a 44% drop compared to the second quarter of this year. But despite the size of the decline, Bank of America is indeed on track to meet this objective. Assuming it does, this gets it to a return on assets of 0.85%.

Conversely, the final 0.15 percentage points won't come as easily. In fact, Bank of America is counting on higher interest rates to do most of the heavy hauling. According to the Charlotte, N.C.-based bank's projections, it will earn an additional $4.6 billion a year in net interest income if short- and long-term rates simultaneously increase by 100 basis points, or a single percentage point. If only short-term rates head higher by this margin, the added revenue comes out to $2.4 billion.

Bank of America CEO Brian Moynihan referred to these estimates in a presentation last week to analysts. Discussing how the bank intends to tackle the final 0.15-percentage point gap, heexplained:

The problem with this is that we have no idea when interest rates are going to rise. It could be later this year, when the Federal Reserve's Open Market Committee meets in December. Or it could be next year. Or, to be frank, it could be five years from now if the situations in Europe and China get worse. Moreover, other banks, such as JPMorgan Chase, Wells Fargo, and U.S. Bancorp, are able to exceed these profitability targets even in today's unprecedentedly low rate environment.

The point is that, while there's no question that Bank of America has made a lot of progress over the last few years, and in the second quarter of this year in particular, it still has a long row to hoe before it's fully and finally able to compete on a level playing field against the industry's best and brightest.

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John Maxfield has no position in any stocks mentioned. The Motley Fool owns and recommends 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.

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