Bank of America (BAC) Analysis

Bank of America (BAC) is a large capitalization stock with a market cap of about 185 billion dollars. BAC is an interesting stock to invest in as it has an increasing divident yield and low P/E. The popular theory in wall street is that the large cap stocks are undervalues compared to their peers in other sectors and are due for a run up. There is another wall street theory also doing the rounds - the international stocks have had huge runups and are due for a correction. This will cause some of the dollars invested in foreign stocks to come home. If these theories hold up, then the likelihood of increased share value in U.S large caps seems likely.

Let us take a look at the BAC financials. It has a dividend yield of 4.3%, P/E of 11 and a market cap of 185 billion dollars. The dividend yield is very attractive especially coming from a company with high credit rating. The 4.3% yield is the same as the ten year treasury note with the added benefit that the dividend yield has been growing at the rate of 11% per year. BAC has been paying out 42% of the earnings as dividends consistently.

Let us take the dividend discout model and run it on this stock. If we assume a dividend growth of 11% per year for the next ten years and a discount rate of 8% for cash we are investing, we get a price of $23/share. The second model is the one available in SmartMoney website. http://www.smartmoney.com/pricecheck/index.cfm?story=worksheet This one automatically fills out many of the factors for the stock once the ticker is entered. It gives the stock a value of 73.25 in five years. This gives the stock a compound growth rate of about 9%/year.

In addition to the models, looking at the most recent quarterly and annual reports will give a better insight into the cash flow and the business risk in various categories. Looking at the 10-Q from the September 05 quarter gives us some insights. BAC's revenues can be split into two main categories - interest income and non interest income.

The main component of the interest income is income from deposits. This component is dependent on the interest rates determined by the federal reserve. The impact on earnings because of the rising interest rates is not fully felt yet. We can start to see the increased impact on earnings in Q2 06. Now there is also the fear among many that the U.S economy is slowing down and will cause the federal reserve to reduce interest rates. The economist magazine ( http://www.economist.com ) has predicted U.S GDP to grow to about 16 trillion by end of 2010 from about 12.5 trillion from now. This gives a GDP growth rate of about 4% per year. Surely, some of the increase in GDP will come from increased exports because of higher growth in the rest of the world. Given the increased tightness in the labor markets and increasing salaries, a significant slow down in 2006 is unlikely. The likelihood of fed rates being a bit higher than what it is today is more likely. If the rates remain the same or go higher, it should translate to better earnings for BAC.

The main components of the non interest income category are service charges, investment and brokerage services, investment/brokerage services and credit card income. There is very little risk in this category and one can look for increased credit card income following the MBNA acquisition. The recent passing of the bankruptcy law bodes well for BAC and other credit card issuers. The good part of the income statement is that the exposure to mortgage banking income is limited. In case the interest rates cause a bursting of the housing bubble, BAC's exposure is limited.

The MBNA acquisition will increase the market cap of BAC and will also cause share dilution. BAC is paying approximately $5 billion in cash to MBNA share holders. In addition, BAC will issue 631 million shares to MBNA share holders. This will increase the outstanding shares to 4.65 billion.

BAC has been buying back shares aggressively. Year over year, the number of outstanding shares have decreased by about 50 million. This will help increase the earnings per share and also the dividends.

The only concern in the balance sheet is the slow growth in shareholder equity. Year over year, share holder equity has increased only by about 1.6%. This could be because of dividend payments and share buy backs. This is the only black spot on otherwise a solid balance sheet.

One can look for about 10-15% year over year earnings/dividend growth for the next year. MBNA acquisition should start adding to the earnings in six months to a year. In the short term, there will be charges related to the acquision as about 6000 employees are let go from the merger. It doesnt hurt that the company has A rating from all the major credit rating agencies. The high dividend yield with potential increase in stock price makes this stock attractive.