Cyclical Tailwinds are Fueling Bank of America's (NYSE:BAC) Rise

Stjepan Kalinic
January 19, 2022
Source: Shutterstock

Where some see the sunset, others see the dawn. It is no secret that the banks had a tough time in the super-low interest rate environment.

Yet, as the FED prepares to lift the rates, it seems that Bank of America Corporation (NYSE: BAC) might have a head start among its competitors – if we are to judge by the first earnings reports.

See our latest analysis for Bank of America

Q4 Earnings Results

  • GAAP EPS: US$0.82 (beat by US$0.06)
  • Revenue: US$22.06b (miss by US$130m)
  • Revenue growth: +9.8% Y/Y

Other highlights:

  • Net interest income: US$11.4b (up 11%)
  • Average deposits: up 16% (now at US$2tn)
  • Dividends and share buybacks in 2021: US$31.7b

After its main competitors had a bumpy earnings release, BAC delivered solid performance across the board. The cyclical tailwinds will allow it to make further retail-friendly adjustments, as they announced reduced overdraft fees from May and eliminated non-sufficient funds fees as early as February.

While there are many data points from the latest report, the growth of average deposits shows the magnitude of the liquidity in the system.

BAC - average deposits through quarters, Source: Investors Presentation

However, despite rate hikes, streamlined profitability, and face buybacks, Societe Generale recently downgraded BAC from Buy to Hold. Their analyst Andrew Lim anticipates a modest increase in rates and a flattening yield curve.

Mr.Lim deems the situation inadequate to keep the ongoing BAC momentum, as the stock comfortably outpaced the broad market in 2021, rising 46%.

Step by step through the intrinsic value calculation

As Bank of America operates in the banking sector, we need to calculate the intrinsic value slightly differently. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. This often underestimates the value of a stock, but it can still be suitable as a comparison to competitors.

We use the Gordon Growth Model, which assumes dividends will grow into perpetuity at a rate that can be sustained. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We then discount this figure to today's value at the cost of equity of 7.3%. Relative to the current share price of US$46.3, the company appears about fair value at a 16% discount to where the stock price trades currently. Remember, though, that this is just an approximate valuation.

Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= US$1.0 / (7.3% – 2.0%)

= US$55.4

NYSE:BAC Discounted Cash Flow January 19th 2022

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate, and the other is the cash flow.

The DCF also does not consider the possible cyclicality of an industry or a company's future capital requirements, so it does not give a complete picture of its potential performance. Given that we are looking at Bank of America as potential shareholders, the cost of equity is used as the discount rate rather than the cost of capital (or the weighted average cost of capital, WACC), which accounts for debt. We've used 7.3% in this calculation, which is based on a levered beta of 1.221. Beta is a measure of a stock's volatility compared to the market as a whole.

Next Steps:

While BAC had an excellent run already, it seems it is still undervalued enough to catch our interest, as the old Wall Street proverb mentions to "leave the last 5% on the table."

Although the valuation of a company is essential, it ideally won't be the only piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued.

For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Bank of America, we've put together three further items you should assess:

  1. Risks: You should be aware of the 1 warning sign for Bank of America we've uncovered before considering an investment in the company.
  2. Management: Have insiders been ramping up their shares to take advantage of the market's sentiment for BAC's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. Other High-Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

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