You'd think that Bank of America (NYSE:BAC) would be just the perfect stock for this environment, given the rising interest rate environment. However, the stock is still trading at a modest price to earnings multiple, even as thecompany continues to reward shareholders through generous share repurchases and dividends. While that earnings multiple is in line with the conservatism seen since the Great Financial Crisis, I have the opinion that over time, the share repurchases should eventually lead to multiple expansion. This is a stock worth buying on any dip.
BAC Stock Price
Prior to the Great Financial Crisis, BAC stock traded higher than $50 per share. It is impressive if not surprising that the stock has recently come close to former levels, as the strong growth since then has helped overcome the immense dilution required during the financial crisis.
BAC Stock Key Metrics
In the first quarter, BAC saw earnings come in at $0.80 per share, down from $0.86 per share a year prior - largely due to the fact that the company benefited from releasing credit provisions throughout 2021. In my view, the better metric to track is that of average deposits. BAC will see some volatility based on interest rates and the strength of the economy, but the long-term trend will be based on its ability to drive an increasing asset base which in turn funds its operating cash flows. BAC has shown strong execution in growing its deposit base, which has grown double digits year over year.
Bank of America 2022 Q1 Presentation
Net interest yields have remained stable at around 1.69%. For reference, net interest yield was2.5% in 2018.
Bank of America 2022 Q1 Presentation
While the stock continues to trade at conservative multiples since the Great Financial Crisis, the company's balance sheet remains very strong due to the greater restrictions placed on it in response to the crisis. The Common Equity Tier 1 Ratio stood at 10.4%.
Bank of America 2022 Q1 Presentation
To compare with levels prior to the Great Financial Crisis, BAC had a 12.0% Tier 1 ratio as of the latest quarter, versus 6.87% in 2007.
Why Is Bank of America Stock Down?
With interest rates rising, shouldn't BAC be simply rising? There are at least two potential reasons why the stock is down. First, there are fears that the rapidly rising interest rates may come alongside a weakening economy.
CEO Moynihan said the following on theearnings call:
So that's why we have significant reserves in case it's harder landing than people at the Fed would like to engineer. And that's why we run the company with such a balance. But generally, a higher sustained rate environment will help us earn a lot more money.
Next, given that the tech sector has crashed so violently, it makes sense that valuations for BAC and other non-tech stocks would fall in sympathy as well.
Is Bank of America Stock Undervalued Now?
This is a tricky question. BAC has traded at conservative multiples for so long that it can be easy to judge that it is not undervalued based on historical multiples. The average Wall Street rating is only 3.96 out of 5.
The average price target of $48 per share represents only 30% upside.
I suspect that these targets reflect skepticism and impatience that BAC can break out of its current multiple range.
Is Bank of America A Good Long-Term Pick?
Yet that impatience may be misplaced. The longer that BAC trades at low levels, the greater number of shares it can repurchase over time. I find it highly likely that the stock does achieve material multiple expansion if it continues generating solid earnings while repurchasing so much stock. This is a company that repurchased $25 billion of stock in 2021 and $28 billion of stock in 2019. Based on the current $295 billion market cap, these numbers would represent almost 10% of shares outstanding. Wall Street consensus estimates call for solid double-digit earnings growth beyond 2022. As discussed earlier, this year's numbers are expected to fall primarily due to 2021 seeing material benefit from release of provisions for credit losses.
Besides growing its deposit base, I can see earnings upside from rising interest rates and more importantly, rising net interest yields. The 10 year treasury rate and 30 year mortgage rate have quickly returned to 2018 levels.
BAC achieved a net interest yield of 2.5% in 2018 - far larger than the 1.69% in this past quarter. Due to exposure to rising short-term rates, BAC won't be able to immediately return to a 2.5% net interest yield, but if interest rates keep rising, then it should move toward that level or higher over the long term. Combined with the fact that deposits are higher than 2018 levels and still growing, this factor alone could account for a sizable increase in earnings.
Let's calculate a back-of-the-envelope projection of that earnings upside. If we assume a 2.5% net interest yield, then the $2.8 trillion in earnings assets would lead to $67 billion of net interest income. That is much higher than the $47 billion of net interest income earned in 2018, largely because earnings assets stood at only $1.98 billion then. Provision for credit losses stood at $3.3 billion in 2018 - if we assume it jumps to $6 billion, then the company might earn $44 billion of net income, or $5.14 in earnings per share.
Is BAC Stock A Buy During The Dip?
We have just calculated that the company might earn around $5.14 in earnings per share if current interest rates remain where they are for the long term. That would place the stock at just 7.2x earnings. After normalizing provision for credit losses, the company earned around $3.03 in earnings per share during 2020 when interest rates plummeted. In other words, this stock is trading at 12x earnings in a low interest rate environment with substantial upside as interest rates rise. What's more, the company is a free cash flow machine, returning more cash to shareholders than net income through dividends and share repurchases.
I expect the stock to re-value higher over the long term - towards an earnings multiple of at least 15x (I would not be that surprised to see the stock approach 20x). The only catalyst needed is what they've already been doing: aggressively repurchase shares and grow the dividend. Sure, that catalyst has not played out over the past decade, but I suspect that it is only a matter of time before investors wake up to this name. It is possible that all the stock needs is an earnings boom from rising interest rates, the kind of macro event that could stir enthusiasm in the stock. There are two key risks here. First, in a weak economy BAC would likely see increased credit losses.
Unlike during the Great Financial Crisis, BAC's balance sheet is conservatively leveraged - purposefully such that the GFC can never happen again. This is an interesting situation in which investors might be punishing the stock for what happened during the GFC, when in reality the GFC has significantly de-risked the business model. Further, any economic weakness arguably should be near term in nature. The more pressing risk is that of disruption. BAC has historically benefitted from offering low to non-existent interest rates on deposits. Many competing firms like Ally Financial (ALLY) offer high-yield savings accounts and newer generations might not be willing to give up those higher rates.
It is possible that BAC has to eventually increase the cost of deposits, or risk ceding deposits to competition. If this occurs, then its net interest yield may struggle to increase, making rising interest rates a necessity. The company continues to aggressively grow its deposit base, but investors should keep a close eye on that key metric. I rate the stock a buy as the large shareholder yield means investors are paid in the near term, with larger long-term upside in the event of multiple expansion.
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