Bank of America

A deep dive into one of the nation's strongest banks

BAC Overview

The Bank of America Corporation (BAC) is a large international bank; it has investment banking arm and a commercial banking arm. It has financial hubs in the U.S., Hong Kong, London, and Toronto. The overall sentiment of the large bank has been that it has done a good job of turning major headwinds to its advantage and become one of the strongest banks that we know today. Note that for the purposes of this article, the (four) major banks are JPM, BAC, WFC, and C, in order of market cap.

In the following article, I will try to give a basic outline of BAC’s financials, a qualitative analysis, and a brief commentary on where I believe the bank is going based on some elementary macroeconomic outlooks.

More than anything, the article that I am writing represents a learning exercise for me on how to value a bank, rather than a report that has something new to say about the bank. I have no new insights to offer in terms of valuation of the bank. I am sure many analysts with access to real time, high quality data have done their due diligence on the valuation of BAC, and you can read their reports if you want to learn more than just the basics. Here I merely outline the bare financial basics and briefly, comment on the banking industry, and what can one expect in the upcoming years. I am taking most of my valuation pointers from The Motley Fool’s Complete Guide to Investing in Bank Stocks, amongst other sources.

An Analysis of the Numbers

First, we dive into the financial fundamentals of any bank that one values. Here, we are going to look at the Return on Assets (ROA), Return on Equity (ROE), and compare them with the industry norms. I have acquired this industry average using Finviz software¹. Ergo, it may be less than accurate. Then, we analyze the Net Interest Margin (NIM), Efficiency Ratio, Coverage for Bad Loans, Net Charge off Rate, and the P/(B or TBV).

Earnings is Key – a Look at Return Ratios

Warren Buffett said that when he looks at a big bank, he looks at earnings first. This is why I will look at ROA and ROE first. BAC’s ROA is 0.7992% and the banking industry’s ROA is 0.88%¹. An ideal bank would have a 1% ROA, JPM and WFC are the only major banks that meet this benchmark. C has a -0.4% ROA, which could be due to nonsystematic risk. Since interest rates are on the rise, all banks should be doing well. BAC is barely meeting the industry average, which suggest they could do better, preferably by increasing Earnings, rather than decreasing its Asset size without affecting Earnings too significantly, which is tough to achieve. There are several ways a bank can increase its earnings (1) cutting (noninterest) costs would be the ideal way of optimizing profits, which is what the Efficiency Ratio (ER) is primarily used for – which is considered good (62.67% - a really well-run bank would have its ratio below 60%. JPM is also around 60-61%)  (2) Take on substantial risk to increase gross revenue at the expense of conservatism – a bad idea, although not a problem one should think oneself invulnerable to. History does have a tendency to repeat itself. (3) Change its policy rates or methods of doing business. Consider changing its rates to better suit BAC’s earnings, or adopt another bank’s more profitable loan strategy. Both methods risk alienating its existing clients. This would obviously be an overhaul of BAC’s system, and for what – an insignificant uptick in Earnings. For BAC’s scale, I think the first option is ideal.

Let’s analyze noninterest expenses.

Noninterest expense (m)	2017	2016	2015
Personnel	31,642	31,748	32,751
Occupancy	4,009	4,038	4,093
Equipment	1,692	1,804	2,039
Marketing	1,746	1,703	1,811
Professional fees	1,888	1,971	2,264
Data processing	3,139	3,007	3,115
Telecommunications	699	746	823
Other general operating	9,928	10,066	10,721
Total noninterest expense	54,743	55,083	57,617
Income before income taxes	29,213	25,021	22,187
Income tax expense	10,981	7,199	6,277
Net income	$18,232	$17,822	$15,910

Noninterest expense seems quite gradual, there does not seem to be any glaringly expensive items. BAC should continue to cut costs where it can to make up for a lower efficiency ratio, as they have proved with this short track record of three years. One minor area that may require a deeper analysis is its data processing fees. Unless there was a significant demand for a large volume of data to be processed, these costs should generally go down. Thus, it is strange that it went up the last year. Long term though, this should not be an issue.

BAC’s ROE is 6.8247%, lower than the 8.44% industry average. This tells us that BAC is not doing as well to its peers and can improve its operations to drive up net income, which will drive up ROE. To look at how safely levered BAC is, we turn to the Debt to Equity ratio and the Long term Debt to Equity ratio, which is 1.79 and 0.85 respectively. Industry D/E is approximately 2.2, which implies the bank is conservative in running its operations. Compared to its peers JPM (1.18), C (1.23) WFC (1.22), it is among the lowest. Interestingly enough, Canadian banks are not likely to take on too much debt, according to their ratios.

BAC’s Net Interest Margin (NIM) is 2.59% - NIM is net interest divided by its total interest-generating assets. The ideal mark is 3%, which indicates BAC is weak in this area and has room for improvement on widening its margins by either taking on a little more risk, or lowering its deposit/borrowing rates.

BAC’s current business model takes a majority (about 71.6%) of its deposits and loans it to customers. Since it is a large bank, it has other areas of business too. An approximate 53% of their liabilities are not in the direct business of loans. Some may be interest generating T-bills from the Fed, but those are not BAC’s main business. We arrive at 53% because 65% of their liabilities are deposits, and 71.6% of their deposits are loans. [35% + (65%*0.716) = ~53.46%]. Its other major assets are trading account assets, “other assets”, receivables from customers, derivative assets, and cash, in order of size. In my estimation, these are profitable and conservative ways to allocate risk and ensure effective growth for a bank the size of BAC. At my level of understanding, I feel unqualified to analyze these assets (or other sources of revenue like investment banking advisory fee and debt/equity spread revenue, for that matter) properly, so I will not attempt to do so in this report. I will only be analyzing its loan portfolio in the report.

The total recorded amount of loans that BAC made in its most recent 10-K report was 937,786m, its total interest income was 44,667m, and its noninterest income was 42,685m. The two income streams are approximately equal, which is consistent with what we outlined in the preceding paragraph.

Next, we look at Coverage for Bad Loans. BAC’s towers at 161%, which is reassuring for investors. We see a trend where BAC is quite conservative in estimating its allowances in relation to actual write-downs of its bad loans. In a booming economy, it may be wise for BAC to increase or at least maintain this number, as this does not really change the economics of the business. It just creates a perception of how it is doing. Net charge-offs is the next logical metric to analyze. The lower the number, the better. BAC’s NCO is a mere 0.44%, which is a good sign that they are not taking incredible risks, as they did before the 2008 crash. Most banks are following this standard, and it is unlikely to change.

Finally, our last financial-related metric is the Non-performing Loan (NPL) ratio. From the figure below, we observe that nonperforming consumer loans and nonperforming commercial loans are 1.19% and 0.28%, respectively. Similar to the NCO, the lower this number is the better. The “ideal benchmark” is below 2%. Thus, BAC is looking good so far.

Nonperforming consumer loans, leases	1.19
and foreclosed properties as a percentage
of outstanding consumer loans, leases

Nonperforming commercial loans, leases	0.28
and foreclosed properties as a percentage
of outstanding commercial loans, leases

BAC is doing relatively well for its size. BAC would fare better if it improved its ER substantially. This would target all the metrics that were less than ideal – ROA, ROE, NIM, ER itself. It is not shouldering substantial risk, as observed in the NPL and NCO; also allowing the Street to view the bank less skeptically and loosen up a little bit, as we observe in Coverage ratio.

Just for a gauge on the Price, we compare P/B and P/TBV. The following summarizes the relevant ratios.

In millions, except per share data

TBV	$195,893
BV	$267,146
BV/OS	$25.51
TBV/OS	$18.71
P/TBV	1.603580
P/B	1.175874

Today’s price: 30.12

The P/B and P/TBV may not be accurate because we have current price divided by book value of 2/22/18.

With this information, BAC stock is trading at 1.1759 Book Value and 1.6036 Tangible Book Value. Banks tend to trade between half to two times its book value. BAC may have a comparatively cheaper valuation because of its conservatism in a raising interest rate environment, but it is appropriate. It is a safe, great business at an appropriate price.

A Deeper look at BAC’s loan portfolio

We have determined that BAC has a relatively conservative policy on making loans to its customers by analyzing the three nonperforming (Coverage, NPL, and NCO) ratios. We also looked at how efficiently BAC generates its (interest) income by using ROA, ROE, ER, and NIM. Exactly which segment of its total loan portfolio is BAC focused on? This section will try to answer that question.

An initial look at BAC’s loan portfolio reveals that a small chunk of its revenue comes from Debt securities. The Average Balance is 435,005m out of Average Balance of its Total Earning Assets of 1,922,061m (about 22.63%). Debt securities are made up of relatively low yield securities from the Federal Reserve, time deposits, Federal funds, and trading account assets. They all average a yield of only 2.213%. In a rising interest rate environment and an aggressive growing environment, this portion of earning assets should increase if BAC wants to hedge its risk against an inevitable downswing.

Loans and leases (1)     :		Amount	% of Consumer loans	Yield
Residential mortgage		197,766	43.85%	3.45
Home equity		62,260	13.80%	4.19
U.S. credit card		91,068	20.19%	9.65
Non-U.S. credit card (2)		3,929	0.87%	9.12
Direct/Indirect consumer (3)		93,374	20.70%	2.81
Other consumer (4)		2,628	0.58%	4.23
Total consumer		451,025		4.73

Next, the consumer portion of BAC’s loan portfolio. This makes up about 49.1% of its total loans and leases portfolio and 23.4% of its total earning assets. Mortgages and Home equity loans make up the bulk of total consumer loans (43.85% and 13.8%). Their yields are reasonable (3.45% and 4.19%), and are much lower than the yields we saw in the housing crisis.

			December 31
(Dollars in millions)			2017	%
Outstandings			$203,811
Accruing past due 30 days or more			5,987	2.94%
Accruing past due 90 days or more			3,230	1.58%
Nonperforming loans			2,476	1.21%

These late payment portions are assuring to the analyst, for obvious reasons. If you have any doubts or unresolved qualms, watch The Big Short and compare these figures to those of the film.

		Outstandings								Nonperforming
		December 31
(Dollars in millions)		2017								2017				2016
Residential mortgage (1)		$203,811								$2,476				$3,056
Home equity		57,744								2,644				2,918
U.S. credit card		96,285								n/a				n/a
Non-U.S. credit card		-								n/a				n/a
Direct/Indirect consumer (2)		93,830								46				28
Other consumer (3)		2,678								-				2
Consumer loans excluding loans accounted		$454,348								$5,166				$6,004
for under the fair value option
Loans accounted for under the fair value		928
option (4)
Total consumer loans and leases (5)		$455,276

Mortgage payments’ nonperforming loans are small, especially when compared to 2006/2007 levels, but home equity loans are relatively larger (about 4% of its small home equity loan portfolio). This carries a low amount of risk – nothing seems out of the ordinary.

The layman pays the highest price for BAC’s loans. U.S. and non U.S. Credit Card yields are a whopping 9.65% and 9.12% respectively, even though they are a relatively small segment in its total consumer loan portfolio (about 20% and 0.8%). This is a healthy way for the firm to profit disproportionately to its overall portfolio. Direct and indirect loans also make up a large chunk of its overall consumer loan portfolio. Its return and risk in its loan portfolio are properly allocated in my estimation.

Finally, the third and most significant portion of its loan portfolio: its commercial loaning arm.

Category		Amount	% of total amount	Yield
U.S. commercial		292,452	62.53%	3.34
Commercial real estate (5)		58,502	12.51%	3.62
Commercial lease financing		21,747	4.65%	3.25
Non-U.S. commercial		95,005	20.31%	2.70

    

Total commercial loans make up about 50.9% and 20.33% of its total loan and leases portfolio and total earning assets respectively. The largest portion of its commercial lending arm is its commercial loan (U.S. or otherwise). The U.S. and non-U.S. commercial loans have been growing by about $15.565b and 1.742b respectively from 2016. Not only are the NPL portions of this arm relatively low, the yields are rewarding as well. BAC should continue growing this healthy segment of the business.

From a quantitative perspective, BAC should lower its efficiency ratio; consider taking on more risk for higher margins, or changing its policy and business model. It is conservative in taking on loans, and an analysis of their loan portfolio reveals that they are, in my estimation, quite effective in allocating risk and return for BAC shareholders. They should focus on cutting costs as they have been doing, grow their commercial lending arm considerably, and shoulder more reasonable risk on their consumer-lending arm. 

Qualitative Analysis

I am going to be looking at a couple of factors in my qualitative analysis – how BAC has embraced technology, how BAC’s management is faring, and a brief history of the bank.

This past January, BAC became the first bank to win the J.D Power and Associates Mobile App Certification, which recognizes “brands that provide an exceptional mobile app experience.” J.D. is a market research company.

Not only does this news highlight BAC’s unabashed embrace of technology, it also shows us how seriously they are taking this initiative and how well they are improving their mobile app that launched in 2007. With this in mind, the bank can save costs by cutting branches and consolidating their services onto one convenient platform – this will drive down their efficiency ratio and improve earnings.

BAC has had a few rough seasons, downswing after downswing. In the early 1900s, nearly 6,000 banks went under, while BAC barely trudged through. In the 1930s, the bank was declared “financially unsound” and The San Francisco Fed called its capital structure was “appalling”. It was thanks to an eleventh hour political operative’s appeal that BAC had managed to survive. In the 1980s, BAC was bailed out in a similar fashion when oil prices surged. Finally, in 2008-2009, BAC was once again “throwing caution to the wind”, making endless and poorly thought-out acquisitions. The Fed had to bail them out yet again at the trough of the cycle.

I put this section of the analysis in because I wanted to show their past mistakes and highlight their current, more conservative policies. We analyzed the numbers. They do not seem aggressive to me. On the contrary, they seem to be quite conservative in making loans (which run the engine of the business) and allowances of bad loans. In an environment of rising rates, economic highs, and encouraging stress test results, BAC stands to gain. Their cheap valuation is encouraging for investors who want a bank that is catching up to its industry leader, JPM. I recommend a hold if you are an investor that wants a long term candidate with some growth potential.