Bank Of America: The Dilution Solution

The results of the stress tests are due to be released today and no doubt, bank stocks have had a great run off of the bottom. The banks have rebounded as that has been the primary goal of the FED and the Treasury. Their desire has been to re-instill confidence in the banking sector. In my mind that creates another question - How should a rational investor that relies on fundamentals define confidence.

• Should confidence be defined by the change in the stock price ?
• Should confidence be defined by improvements in the valuation ?

Often times longer term stock price movement is a reflection of improving valuations. A cheap valuation is a catalyst for buyers to step in and bring price to reasonable levels. If the valuation does not keep pace with the price, then the stock could be considered “over valued or rich”. It’s at the point of “over-valuation” that the price starts to move down - heading back down to keep pace with its’ fundamental valuation level.

If you look closely at the chart of BAC over the last several years….You can see that Bank of America (BAC) stock has been in a state of decline. If you look at the earnings per share (triangles), you see that earnings have also been declining along with share price. After numerous rule changes - and accounting trickery, BAC has now suddenly converted to profitability and the stock price has moved up off the floor. The question is CAN THIS PRICE IMPROVEMENT CONTINUE ?

There are several factors that determine earning per share of financial institutions - Cost of Funds and Shares Outstanding. All large banks are constrained by competition and therefore each bank individually has very little pricing power. They must offer loans at rates that are competitive with other banks- failure to do this will result in those banks not getting the “deals” done.

If we look at BAC’s earnings and Shares outstanding we get an interesting picture. We see a declining overall level of earnings and a rapidly expanding share base.

You can see from above that the shares outstanding has increased dramatically since 2004.

As of today there are approximately 6,400,950,000 shares outstanding (based on the information that I’m able to uncover via SEC filings and Fidelity’s website.

If the Stress test today reveal that additional capital is needed by BAC, then this will result in serious further dilution to existing holders of common stock. If BAC needs in the vicinity of $34billion and this capital comes as a result of a conversion of prior TARP monies that were granted to BAC , simple math would suggest that the share base will increase further from current levels

$34Billion divided by $12.00 share price = 2.8 billion MORE SHARES

Potentially this type of Conversion would mean that BAC’s share base is now approaching 10bb shares of common stock. The bank must earn at least $10bb to earn $1.00 per share. In 2007 the bank was able to earn $14bb. In 2008 the bank earned a paltry $2bn. If the bank does not show significant improvement in earnings over the next couple of quarters then you could expect the price of the stock to decline ;

Also any improvement in the share price will now also be affected by the US Government OVERHANG. When and if the share price shows improvement - holders of BAC will be trying to get out of their position along with Uncle Sam. I think that owning the bank stocks entail many different risks. We’ve heard that there is more bad news to come on the employment, commercial r/e and credit card front. Negative news and earnings will continue to reduce the potential for the banks to significantly grow earnings over the next several quarters. I”m not sure that we’re completely out of the woods with regards to the bank stocks.

A bleak economic environment is certainly not a beacon for wary stockholders.

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Comment by J. Beam

2009-08-08 18:37:28

BAC traded as high as $15.07 the day of article. By the next Friday BAC fell to a daily low of $10.58. Somewhere in between that high and low seems like fair value to me. The 8/7/2009 close of $16.42 seems overvalued to me.

Has the economy improved enough to raise fair value on BAC 28%. Or is there something else at work that I just don’t see?

JB

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Comment by dwight

2009-08-10 23:10:20

The increase in share value is due to the valuation of the company. It’s not that the price increased to a new high price as much as that it was oversold earlier this year when people worried BAC would go bankrupt. Lately, investors’ views are that the low valuation needed to be corrected. Personally, I see the price will go to $25 by next summer, and $35 within 3 years. That combined with the return of the dividend ( sometime in the next several years ) should make an appealing case for people to get in early before the fund managers grab up more stock on improving profitability.

It’s tempting to buy a company at $15 that should be at least $25 based on industry positioning and the poor industry performance which will be improving next year. Especially if it may be giving a 10% yearly dividend on your original investment in 3 years and you have the possibility for profit taking on its way there.

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