Ask Matt: Should I buy bank stocks like Bank of America?

ByABC News
March 14, 2012, 8:54 PM

— -- Q: Is now a good time to buy bank stocks, including Bank of America?

A: It used to be bank-stock investors were considered to be boring. Then, after the financial crisis, investors who bought bank stocks were seen as crazy. Now some are starting to look smart.

So far this year, the financial stocks are up more than 18%, topping the 11% gain by the Standard & Poor's 500. Financial stocks are behaving much better this year as fears of the European debt crisis spreading subside and investors are more comfortable with the health of the U.S. economy.

Even so, are investors wise to jump back into bank stocks as the cleanup takes place? To find out, investors can put Bank of America's stock through four tests considered at Ask Matt, including:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Bank of America's trading history back to 1986, we see the company generated an annual compound rate of a loss of 7.0%. That's clearly a disappointing performance if you consider the S&P 500 returned an annualized 9.2% return over the same period, says IFA.com.

But to get that worse-than-average return, you had to take greater risk. You accepted risk — standard deviation — of 44 percentage points. If you don't believe the statistics, just ask any bank investors who sat through the financial crisis in 2008 how risky bank stocks can be. So, by investing in Bank of America, you took on 178% more risk to get a lackluster return. After doing this analysis, you can see why investors are so cautious about bank stocks now, after being so fond of them before the financial crisis.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs.

When we run Bank of America's stock, we find it's rated "very dangerous." In other words, the current stock price is well above the value of what the company is expected to generate in cash over its lifetime. NewConstructs charges for its reports, but is offering its Bank of America report free to Ask Matt readers.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. Even if the company can increase earnings 6% a year the next five years, that would put the stock in the "sell" range. This indicates the stock is not a bargain relative to the earnings the company is expected to generate.

Step 4: Check the company's financial health. Before investing in any company, you want to make sure it's in good financial shape. A quick way to check is to look at where it falls on the USA TODAY Stock Meter, which ranks stocks from conservative (1) to aggressive (5). Bank of America scores a relatively aggressive 3.7 here. You can get a Stock Meter score for almost any stock by going to money.usatoday.com and putting the stock's ticker symbol or company name into the Get a Quote box.