1 Mistake Investors Make With Bank of America

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There's one thing that's been perfectly clear in the wake of the financial crisis: Bank of America's (NYSE: BAC  ) bottom line is painfully anemic. After notching $21 billion in net income in 2006, the megabank hasn't been able to break $7 billion in annual profit for going on six years.

The lackluster profit showing also means that a key measure of bank profitability -- return on equity -- looks terrible. Over the past 12 months, BofA's ROE has been just 2.8%, as compared to an impressive 13.5% at Wells Fargo  (NYSE: WFC  ) and 12.2% at JPMorgan Chase  (NYSE: JPM  ) .

Bank of America has some excuse over the past year in the form of billions of dollars spent on legal settlements -- significantly more than either Wells or JPMorgan. But for the most part, those ROE numbers show exactly what it looks like: The businesses at Wells and JPMorgan are vastly outperforming BofA.

But it gets a bit trickier when it comes to valuation. Because banks are balance-sheet-based businesses, price-to-book value is one of the most commonly used valuation metrics in the banking industry. On that measure, BofA's stock looks staggeringly cheap -- right now it trades at more than a 30% discount to its book value. 

While that sounds like a screaming value, many investors shrug it off because of the large amount of goodwill and other intangible assets that Bank of America has on its balance sheet. Those investors would argue -- with good reason -- that to get a more realistic picture of BofA's valuation, price-to-tangible-book value should be used. On that basis, Bank of America's stock is trading at a slight premium to its tangible book value.

After that change to our valuation calculation, we're now looking at a very different picture. If we adjust BofA's trailing 12 months net income for the big lawsuit payout, we're looking at an ROE of somewhere around 4.4% -- which is still pretty bad -- against a price-to-tangible-book value of greater than one. That hardly seems attractive. But it's also the wrong way to think about it.

If we're basing BofA's valuation on tangible book value, we should likewise be basing its returns on tangible book value. Given that the bank had $141 billion in tangible equity at the end of last quarter versus $231 billion of total equity, this makes a big difference. Measure the returns against the tangible equity and the result climbs to a still not wowing but much more respectable 7.2%.

What this doesn't change is the fact that Bank of America still has a long way to go. Cost cutting needs to continue, smart loans need to be made, and it needs to put the rest of its legal liabilities to bed. But, in the meantime, let's not wrongly punish the company by stacking numbers that don't belong together.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 04, 2013, at 8:56 AM, mpr120001 wrote:

    It is the federal government that has destroyed this country and they need to be punished for their crimes - when is this going to happen?

  • Report this Comment On October 06, 2013, at 8:10 AM, cmalek wrote:

    No matter how you dice, slice and/or spin the numbers BAC still has a long way to go to become a good company. You sound like a typical Wall Street analyst trying to convince the public to buy junk stock.

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