Please ensure Javascript is enabled for purposes of website accessibility
Free Article Join Over 1 Million Premium Members And Get More In-Depth Stock Guidance and Research

Here's Why Bank of America's Shares Trade for a Discount to Book Value

By John Maxfield - Jul 8, 2015 at 2:44PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Because Bank of America doesn't earn enough money each year to satisfy its cost of equity, investors will only buy its stock at a discount.

Shares of Bank of America (NYSE: BAC) trade for a discount to book value because the $2.1 trillion bank earns significantly less than its so-called cost of equity.

Bank of America is the nation's second-biggest bank by assets. It holds more domestic deposits than any other American institution. And, since the financial crisis, it also controls one of the world's preeminent brokerage companies, Merrill Lynch.

But despite these credentials, Bank of America's shares persistently trade for a discount to book value -- and not a minor discount, either. Shares of the North Carolina-based bank are currently valued at 78% of book value. Thus, while Bank of America's assets exceed its liabilities and preferred stock by $228 billion, the market is valuing the company at only $175 billion.

Generally speaking, a bank's shares will trade for a discount to book value if the bank doesn't earn its cost of equity, which compensates investors like you and me for three things.

The first is the risk-free rate of return, typically represented by the interest rate on long-term U.S. government bonds. The second is the stock market's historical rate of return relative to the risk-free rate of return. And the third is idiosyncratic risk, which is the historic volatility, or "beta," of a particular stock.

Here's how this works out for Bank of America: The current risk-free rate of return is 2.25%, the stock market's historical rate of return is in the neighborhood of 8%, and Bank of America's beta is 0.84. Add these together, and you get an 11% cost of equity.

This means that Bank of America must generate a return on equity of at least 11% to fully compensate its investors for the risk, or "cost," of owning its shares. If it earns less than that, which it has since the crisis of 2008-09, then something has to give. And that something is its share price -- or, rather, its share price relative to book value per share.

To better understand this relationship, it's helpful to think about the give and take between the price of a bond and the prevailing yield for similar securities. Let's say you paid $100 for a 10-year government bond that yields 2%, or $2 per year, in interest payments. Six months later, the government issues a new round of 10-year bonds yielding 3%, or $3 a year. If you now want to sell your bond, you'll have to lower the price to $67; it's at this price that $2 in annual interest payments equates to a 3% yield.

When it comes to bank stocks, in turn, the give and take is between a bank's return on equity and the value of its shares. If a bank's return on equity is lower than its cost of equity, then its shares will generally trade for less than book value. If bank's return on equity exceeds its cost of equity, then its shares will generally trade for more than book value.

It's this relationship, in turn, that explains why Bank of America's shares trade for such a large discount to what they otherwise seem to be worth. Over the past 12 months, the bank has earned a mere 3.8% on its equity. That's 7 percentage points below its 11% cost of equity. It accordingly stands to reason that investors are demanding a 22% discount to book value in order to offset the deficiency.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Bank of America Corporation Stock Quote
Bank of America Corporation
BAC
$44.77 (1.42%) $0.62

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

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
633%
 
S&P 500 Returns
140%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 12/07/2021.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Our Most Popular Articles

Premium Investing Services

Invest better with the Motley Fool. Get stock recommendations, portfolio guidance, and more from the Motley Fool's premium services.