Valuing Bank of America

By Brian Burns, author of Trading Stock Options

With more than $2 trillion in assets,

Bank of America

(BAC) - Get Report

is the largest bank holding company in the U.S. You may bank there or know someone who does. After all, in its second quarter 10-Q, the bank said it had more than $970 billion in deposits. It's no surprise that this bank would be considered too big to fail and was subject to government aid through the Troubled Asset Relief Program and the Term Asset-Backed Securities Loan Facility.

The stock market has had an incredible run since the March lows, but the dust may be far from settled as Bank of America acknowledges that 3% of its more than $942 billion outstanding loans are considered "nonperforming."

Through this financial crisis, the bank has tried to capitalize on its size by picking up

Merrill Lynch

, with help from Uncle Sam, and

Countrywide

. Both acquisitions, in particular the Merrill acquisition, have thrown CEO Ken Lewis into hot water, not only with shareholders but with the

Securities and Exchange Commission

. In fact, Lewis lost his position of chairman in April 2009 but has still retained his CEO title.

Even with a cloud of about $45 billion in TARP funds debt still visible overhead, new uncertainties approach -- a jobless rate of close to 10%, which could inflict another round of loan losses; and a bank regulation plan recently announced by President Obama. This plan, which the president describes as "a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression," is going to have an impact on how the bank operates and is regulated.

Would you be surprised to hear that through this recent environment you could have had a 440% gain by purchasing BofA stock? On March 6, the shares were worth $3.14 each. On Sept. 11, the stock was sitting at $16.97 a share. Why has BofA, and the other financials, such as

Wells Fargo

(WFC) - Get Report

and

JPMorgan Chase

(JPM) - Get Report

, risen so much in the past six months and how can you calculate what Bank of America should be worth per share? There are countless ways to put a value on a stock, and many admit that stock valuation is more of an art than a science.

Two metrics I like to look at are the book value per share ratio, also known as the price/book ratio, and the Tier 1 capital per share ratio. Book value per share can be calculated by taking a look at the company's balance sheet and subtracting the liabilities from the assets. This unadjusted book value is going to be the same as the shareholder's equity number on the balance sheet; I say unadjusted because you can further decrease the assets on the balance sheet by subtracting intangibles, like goodwill, preferred equity, or further discounting the company's loans outstanding. You then determine how many shares outstanding the company has, take the unadjusted book value divided by the shares outstanding, and you will have the book value per share.

As of the second quarter, using the current shares outstanding as of September, the company had an unadjusted book value of $29.50 a share. Divide the average price per share the stock was trading at during the second quarter by the book value per share and the book value per share ratio is 0.37.

A Tier 1 capital per share ratio is another metric used to value a bank holding company. Tier 1 capital is a regulatory measure of a bank's financial strength. According to regulatory standards, BofA was classified as "well-capitalized" as of the second quarter of 2009. The total Tier 1 capital can be found by going through the bank's 10-Q; the 10-Q can be found by going to the SEC's Web site.

You can create a Tier 1 capital per share and Tier 1 capital per share ratio similar to how the book value per share and book value per share ratio were calculated. As of the second quarter, BofA had a Tier 1 capital per share of $36.45, which calculates into a Tier 1 capital per share ratio of 0.30. The per share ratios for both book value and Tier 1 capital were derived by using the company's average share price for the quarter.

By themselves, these two metrics may not have much meaning for you; the question is whether or not Bank of America is trading at an appropriate ratio. Take a look at the changes to both, the book value per share ratio and Tier 1 capital per share ratio, since the first quarter of 2000.

Since 2000, the stock has traded at an average book value per share ratio of 1.55 and a Tier 1 capital ratio of 1.00. While many will argue that this crisis has changed valuation methods, most long-term investors should invest at a time when valuations are substantially deviated from the norm. I'll concede that the valuation average may not be reached anytime soon, but consider these metrics: a Tier 1 capital per share ratio of 0.50 or a book value per share rate of 0.775.

If using the Tier 1 capital per share ratio of 0.50, BofA would be valued at $18.22. If using a book value per share ratio of 0.775, the stock would be valued at $22.13. The average between those two valuations is $20.17, 18.8% above the closing price of $16.97 on Sept. 11. And if BofA is able to return back to the valuation mean of the past the upside potential for Bank of America could be substantially more given the potential earnings power of the Merrill and Countrywide acquisitions.

At the time of publication, Burns was long BAC.