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Passing the Stress Test is Worth Billions to These 3 Banks

By Matthew Frankel, CFP® – Jul 6, 2016 at 2:48PM

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It's not the dividend increases that are important to these banks' shareholders.

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It was recently announced that the Federal Reserve had approved the capital plans of most major banks, and it was subsequently revealed that many banks are increasing their dividends, buybacks, or both. While the stress test results should be welcome news to anyone invested in U.S. bank stocks, shareholders of Bank of America (BAC -1.64%), Citigroup (C -1.44%), and Goldman Sachs (GS -0.75%) should be especially happy.

The capital plans

After the results of the stress tests were announced, several banks announced they would be increasing dividends, buybacks, or both. In the cases of Bank of America, Citigroup, and Goldman Sachs, here are the details:

  • Bank of America increased its quarterly dividend by 50% to $0.075 per share, and authorized a $5 billion stock buyback. The dividend increase means the bank will pay roughly $3 billion in dividends over the next year.
  • Citigroup announced a dividend increase to $0.16 per share (about $1.9 billion per year), as well as a $8.6 billion buyback.
  • Goldman Sachs said that its approved capital plan includes stock buybacks and a dividend raise, however the bank did not elaborate on the exact amounts.

Why buybacks are the most important part

As you can see, Bank of America and Citigroup are spending significantly more money on stock buybacks than dividends. And while we don't know Goldman's exact plans yet, they have historically emphasized buybacks, and I don't expect this to change. For investors, this is great news.

In a nutshell, the buybacks are the most important thing for these three banks because they all trade for substantial discounts to the value of their assets.

BAC Price to Tangible Book Value Chart

When you add intangible assets such as branding, goodwill, patents, etc., the price-to-book valuations look even more attractive.

BAC Price to Book Value Chart

In other words, these banks can buy their own assets back for significantly less than they're worth. Think of it this way – if you could buy hundred-dollar bills for $80, wouldn't you buy as many as you possibly could?

Instant value creation

If you could buy a hundred-dollar bill for $80, you'd be creating an instant $20 in value for yourself every time you bought one.

Similarly, these banks are creating instant value for shareholders when they buy back their own stock at such depressed valuations. Consider Bank of America's case, and its recently authorized $5 billion buyback. As of this writing, Bank of America shares are trading for $13.11, and the bank's most recently reported tangible book value is $16.17 per share. This means that Bank of America instantly creates $3.06 in value for each share it buys back at this price level.

With a $5 billion authorized buyback, Bank of America could buy more than 381 million of its shares, which would create about $1.17 billion in automatic shareholder value. Even more impressive, based on the book value of $23.12, which includes tangible assets, $3.8 billion of instantaneous value will be added.

Based on the number of shares that would be left after the buyback, this translates to about $0.38 in new value per share just because of buybacks at a discount. This is on top of the inherent increase in value that would already come with buying back nearly 4% of the company's outstanding shares.

Now, I realize that the entire $5 billion buyback won't take place at the current share price. Rather, it will occur gradually. Still, the potential to create value for shareholders is enormous. Besides, I would expect the banks to be rather aggressive with their buybacks while shares are so cheap.

Time to buy?

The bottom line is that these banks are right to emphasize buybacks over dividends while share prices are so low. These banks certainly are not without risk, but I feel that the current valuation more than makes up for it. As I said before, the market is giving you the opportunity to buy $100 bills for $80. I've taken advantage of low bank stock prices this year, and you can do the same.

Matthew Frankel owns shares of Bank of America and Goldman Sachs. The Motley Fool recommends Bank of America. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Stocks Mentioned

Citigroup Stock Quote
Citigroup
C
$47.09 (-1.44%) $0.69
Bank of America Stock Quote
Bank of America
BAC
$35.95 (-1.64%) $0.60
Goldman Sachs Group Stock Quote
Goldman Sachs Group
GS
$380.93 (-0.75%) $-2.88

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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