Image source: The Motley Fool.
If you're going to invest in Bank of America (BAC -1.07%), there's one question that you need to come to terms with: Can the nation's second biggest bank by assets earn its cost of capital? The answer to this dictates Bank of America's shareholder returns as well as its valuation.
I sometimes feel like I write about this issue all the time, which is probably because I do. But I cover it so frequently because it cuts to the heart of any investment thesis associated with Bank of America's stock, which is one of the most heavily traded stocks in the United States.
A bank's cost of capital is what it must earn, measured by return on equity, in order to compensate investors for the risk of owning its stock plus the opportunity cost of not owning other productive assets. If a bank's return on equity doesn't exceed this, then shareholders could earn a better risk-adjusted return elsewhere.
In Bank of America's case, its return on equity has come up short of its cost of capital for eight consecutive years. Last year was its best showing, but even then its return on equity equated to only 6.3%, which is half its 12.2% cost of capital.
But investors don't make money looking backwards; you make money by trying to peer into the future. In this case, then, the question is less about why Bank of America hasn't earned its cost of capital in the past and instead more about whether it'll be able to do so in the future.
This is where the chart that I allude to in the headline comes into play. It shows us the change in Bank of America's capital and liquidity since 2007. Take a look at the magnitude of the increases of both below -- I'll explain what they mean under the chart.
Data source: Bank of America. Chart by author.
As you can see, Bank of America holds much more liquidity (cash and equivalents) and capital (tangible common equity) today than it did before the crisis -- roughly four times as much liquidity and three times as much capital. This is the result of new regulations passed in the last few years that are designed to make the bank industry safer.
The problem with these regulations is that they weigh directly on a bank's profitability -- its return on equity. Highly liquid assets yield either nothing or very little. Consequently, the larger the percentage of assets allocated to things like cash and equivalents, the less a bank earns from its loan and securities portfolios.
The same is true when it comes to capital. As a matter of arithmetic, there's a direct relationship between a bank's leverage and its profitability. If you reduce the former, which is done by requiring banks to hold more capital, then you necessarily reduce the latter. And that's exactly what the post-crisis regulations have done by mandating that the nation's biggest and most systematically important banks in particular hold more capital relative to their assets than they did in the years leading up to 2008.
Investors must thus reconcile whether or not they believe that Bank of America will be able to earn its cost of capital not today, but in the future given these constraints. Bank of America's executives are obligated to say that they can, as its CEO, Brian Moynihan, did at a recent conference, but whether they will be able to make good on his claim remains to be seen.
