Warren Buffett has said that he got the idea to invest in Bank of America (NYSE: BAC) while taking a bath in 2011. He agreed to invest $5 billion into the bank, which was struggling at the time and finished the year as the worst performer in the Dow Jones Industrial Average.
Buffett has held on to that stake and added to it over time, for a total of nearly $15 billion in investments, which are worth roughly $46 billion today.
The recent turbulence in the economy has shaken investor confidence, allowing you to scoop up shares of top businesses at discounted prices. Here is why Bank of America is worth considering as a buy today.
Profit on rising interest rates
The Federal Open Market Committee, which consists of leadership from the Federal Reserve, is in charge of setting monetary policy in the United States. It can raise and lower the federal funds rate, which dictates the rate at which banks can borrow money from one another.
The federal funds rate is the primary tool used to manage inflation; you can see below how it correlates with inflation over the long term. Inflation has soared since 2020, which is why you’ve heard a lot about rising interest rates.
Bank stocks are sensitive to interest rates because banks make money by lending and capturing the difference between the interest rate they borrow at and what they charge borrowers.
It’s much harder to create that spread when interest rates are low, so rising rates are a good thing for Bank of America and other lenders. Interest rates rising to decade highs would likely create a more-profitable market environment for Bank of America.
Get paid to hold shares
Despite low interest rates, Bank of America has still done well over the past decade. The company’s bottom-line profits over the past four quarters totaled $31 billion, leaving lots of cash to return to shareholders.
The company pays a quarterly dividend with a 2.6% annual yield and a payout ratio of just 26%, meaning the bank can easily afford it. The rest of the company’s profits go to massive share repurchases; the number of outstanding shares has fallen 25% over the past decade, boosting per-share financials like earnings per share (EPS).
The valuation is attractive
At Wednesday’s prices, Bank of America was trading near $33, just above its 52-week low. The broad sell-off in the market is likely to blame for the stock’s tumble, as investors are increasingly fearful of a recession, which can reduce demand for consumer loans.
But rising interest rates can boost a bank’s profitability, which you can see in the chart below. Return on equity (ROE) is profit as a percentage of shareholder’s equity. Bank of America’s ROE is its highest in a decade, which likely isn’t a coincidence as rates keep rising.
The stock’s price-to-book ratio has fallen to 1.1, its lowest since the COVID-19 market crash in 2020. The stock was cheaper earlier in the decade, but the business is generating a much higher ROE, so a higher valuation is justified.
Bank of America is one of the largest lenders in America, and regulations have been put in place to help prevent the type of financial crisis that helped send the bank stumbling more than a decade ago. Higher interest rates will likely be a tailwind for profits, so the current dip in the stock seems like a solid opportunity to get in on one of Warren Buffett’s most successful investments.
Bank of America is an advertising partner of The Ascent, a Motley Fool company. Justin Pope has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.