What Type of Investor Buys Bank of America's Stock?

Bank of America's stock isn't for everyone. Image source: DigitalVision/Thinkstock.

Only a certain type of investor should consider buying Bank of America's (BAC -0.21%) stock. This isn't because it's a good or bad bank, but rather because its characteristics rule out other investment strategies.

Bank of America is an attractive option for investors that are looking for bank stocks trading below their historical valuation. The price-to-book value ratio is the most common way to value a bank stock. It's calculated by dividing a bank's share price by its book value per share.

Generally speaking, banks are considered cheap if their price-to-book-value ratio is below 1.0. Bank of America satisfies this, as its shares currently trade at only 61% of its book value. This is less than Bank of America's better-heeled peers such as JPMorgan Chase (JPM 0.06%) and Wells Fargo (WFC -0.03%), though it exceeds Citigroup's (C 1.41%) valuation.

Source: Yahoo! Finance.

A frequently cited rule of thumb is that you should buy bank stocks at half of book value and sell them at two times book. This is easier said than done, of course, because investors are typically weary of banks that aren't valued by the market for at least as much as they're ostensibly worth.

Additionally, banks that trade for less than book value tend to be cheap because they don't earn their cost of capital. This is a theoretical concept that reflects the opportunity cost of investing in a specific stock. If a bank doesn't earn enough to exceed the average return of, say, a low-cost exchange traded fund that tracks the S&P 500, then there's no reason an investor shouldn't prefer the latter over the former.

A good benchmark in this regard is that a bank's annual net income must be greater than or equal to 10% of its shareholders' equity. That's a sign that it's exceeding its cost of capital. If a bank's return on equity is less than this, though, it's effectively destroying shareholder value when you consider that investors could be earning a higher return elsewhere.

This explains why Bank of America's share are so cheap. Its return on average common shareholders' equity last year was only 6.26%. That's an improvement over the prior year, when the figure was 1.70%, but it's nevertheless below the $2.1 trillion bank's cost of capital.

Data sources: Fourth-quarter earnings releases from Wells Fargo, JPMorgan Chase, Bank of America, and Citigroup.

Given this, it's my opinion that the only type of investor who should be interested in buying Bank of America's shares are those who believe a turnaround is imminent. This would result in higher profitability and, thereby, a higher stock valuation, which could be catalyzed by an aggressive buyback campaign, assuming regulators allow Bank of America to conduct one.

I personally believe Bank of America's turnaround is in its final stages. It's thrown off much of the yolk from the financial crisis and has already begun to see its earnings respond in kind. But because this remains speculative, investors on the hunt for a set-it-and-forget-it bank stock would be better off with Wells Fargo or JPMorgan Chase. They earn more money than Bank of America (and Citigroup) and have proved over time to be much safer investments.