Pricing bank stocks such as BAC is particularly challenging. Given that these companies adhere to a different set of rules relative to other companies, their cash flows should also be valued differently. The tiered capital structure is common for banks to abide by, in order to ensure they maintain a sufficient level of cash for their customers. Looking at line items such as book values, on top of the return and cost of equity, can be fitting for computing BAC’s value. Today I’ll look at how to value BAC in a fairly useful and straightforward way. See our latest analysis for Bank of America
What Model Should You Use?
Financial firms differ to other sector firms primarily because of the kind of regulation they face and their asset composition. Strict regulatory environment in United States’s finance industry reduces BAC’s financial flexibility. In addition to this, banks generally don’t possess large portions of physical assets as part of total assets. As traditional valuation models put weight on inputs such as capex and depreciation, which is less meaningful for finacial firms, the Excess Return model places importance on forecasting stable earnings and book values.
The central assumption for Excess Returns is, the value of the company is how much money it can generate from its current level of equity capital, in excess of the cost of that capital. The returns above the cost of equity is known as excess returns:
Excess Return Per Share = (Stable Return On Equity – Cost Of Equity) (Book Value Of Equity Per Share)
= (11.58% – 9.92%) * $25.91 = $0.43
We use this value to calculate the terminal value of the company, which is how much we expect the company to continue to earn every year, forever. This is a common component of discounted cash flow models:
Terminal Value Per Share = Excess Return Per Share / (Cost of Equity – Expected Growth Rate)
= $0.43 / (9.92% – 2.47%) = $5.79
Putting this all together, we get the value of BAC’s share:
Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share
= $25.91 + $5.79 = $31.7
Relative to the present share price of $29.3, BAC is currently fairly priced by the market. This means BAC isn’t an attractive buy right now. Pricing is one part of the analysis of your potential investment in BAC. Analyzing fundamental factors are equally important when it comes to determining if BAC has a place in your holdings.
For banks, there are three key aspects you should look at:
- Financial health: Does it have a healthy balance sheet? Take a look at our free bank analysis with six simple checks on things like bad loans and customer deposits.
- Future earnings: What does the market think of BAC going forward? Our analyst growth expectation chart helps visualize BAC’s growth potential over the upcoming years.
- Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether BAC is a dividend Rockstar with our historical and future dividend analysis.
For more details and sources, take a look at our full calculation on BAC here.