Bank of America Is Overvalued

The bank is overvalued relative to its justified valuation metrics

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Sep 20, 2022
Summary
  • Justified and threshold financial ratios suggest Bank of America is overvalued.
  • Waning capital markets revenue and resilient inflation adds stress to the bank's income statement.
  • A robust dividend is a positive, but investors should note the risks involved.
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Bank of America Corp. (

BAC, Financial) is one of the most frequently traded bank stocks, with average daily volume touching 40 million shares. Due to its popularity among investors, the asset will likely trade near fair value as its liquidity dilutes price arbitrage.

In light of the rising economic turbulence and stock market volatility, I have taken it upon myself to place a valuation on the stock and cover a few idiosyncratic features. Here is what I discovered.

Valuation

Banking stocks tend to oscillate around their price-book ratios as their businesses essentially function by trading quoted assets. Ideally, a bank's price-book ratio should sit below 1 for the security to be considered undervalued; however, according to GuruFocus' latest data, Bank of America is overvalued at a price-book value of 1.14.

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Taking it a step further, I computed the justified price-book ratio, which is a company-specific adjustment of the fair value threshold. In other words, Bank of America's company-specific value threshold is 1.13 instead of a theoretically generalized 1. However, even from this vantage point, the stock is priced in as its market-derived price-book ratio is within the same range (if not marginally above).

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Source: Author's calculations.

Lastly, I computed the stock's justified price-earnings ratio. Although this ratio is less relevant for banks, it still bears substance as it assesses a stock's earnings capacity relative to its market traded price. According to GuruFocus data and my calculations, Bank of America's price-earnings ratio exceeds its justified threshold; therefore, the stock is arguably overvalued.

Operational review

To eyeball the stock's future prospects, observing the underlying company's operating results is necessary.

Bank of America has been off the pace recently. The bank missed its second-quarter earnings target by 2 cents per share amid stumbling stock and bond markets.

The company's non-interest income declined by 9% year over year due to adverse capital market activities and a downward reversion in investment banking activities. However, the bank's lending operations remained robust, with a 22% year-over-year increase primarily due to rising interest rates and consumer loan demand persistence, which is expected during late economic expansions.

Having said that, Bank of America increased its provision for credit losses to $2.1 billion, indicating it expects credit risk to exacerbate. Additionally, the bank's CET1 ratio of 10.5% remains above the regulatory threshold, but does not provide much of a margin of safety in a questionable economy.

Dividends

To assess Bank of America's total return prospects, it is necessary to evaluate the bank's dividend profile. Bank of America experienced rapid dividend growth over the past five years at a compound annual rate of 24.70%, achieving a current dividend yield of approximately 2.40%.

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Are these dividends sustainable?

Based on Bank of America's dividend coverage ratio of 3.71 and cash from operations of $3.97 billion, its dividend is as safe as houses.

However, investors should account for macroeconomic headwinds that could dampen the bank's cash flows and, in turn, hinder dividend payouts. To elaborate, resilient inflation threatens Bank of America's lending activities, while a recession could squander service-based banking activities and allocate more obstacles toward its capital markets division.

Concluding thoughts

Bank of America is slightly overvalued amid elevated market-based valuations and rising macroeconomic concerns. Investors could opt to stay invested in the stock for its highly lucrative dividend profile, but systemic risk needs to be tracked closely.

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
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