Below I’ll walk you through two tools an ASX investment analyst would use to provide share price ‘target’ on a company like Westpac Banking Corp (ASX:WBC).
Obviously, I’m going to show you the shortcut or easy version, then provide some further resources and offer potential indicative valuations, using WBC shares as my case study. I think it goes without saying but these valuations are not guaranteed.
Bank shares like Westpac Banking Corp, Bank of Queensland Limited (ASX:BOQ) and National Australia Bank Ltd. (ASX:NAB) are very popular in Australia because they tend to have a stable dividend history, and often pay franking credits.
While I explain the basics of investing in bank shares in this article, if you’re interested in understanding the value of dividend investing in Australia, consider watching the video from the education team at Rask Australia.
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Flipping the PE
The PE ratio compares a company’s share price (P) to its yearly profit per share (E). ‘Earnings’ is another word for profit.
There are three easy ways to use the PE ratio. First, you can use ‘intuition’ and say ‘if it’s low, I’ll buy shares’ or ‘if it is above 40x, I’ll sell shares’ (whatever works for you). Secondly, you can compare the PE ratio of a stock like Westpac Banking Corp with NAB or the sector average. Is it higher or lower? Does it deserve to be more expensive or cheaper? Third, you can take the earnings/profits per share of the company you’re valuing and multiply that number by a PE multiple that you believe is appropriate. For example, if a company’s profit per share (E) was $5 and you believe the stock is ‘worth at least 10x its profit’ it would have a valuation, according to you, of $5 x 10 = $50 per share.
Using Westpac Banking Corp’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 9.9x. This compares to the banking sector average of 10x.
Reversing the logic here, we can take the profits per share (EPS) ($1.644) and multiply it by the ‘mean average’ valuation for WBC. This results in a ‘sector-adjusted’ share valuation of $16.85.
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Dividend discount modelling
A dividend discount model or DDM is a more robust way of valuing companies in the banking sector.
DDM valuation models are some of the oldest valuation models used on Wall Street and even here in Australia. A DDM model uses the most recent full year dividends (e.g. from 2019/2020) or forecast dividends for next year and then assumes the dividends remain consistent or grow slightly for the forecast period (e.g. 5 years or forever).
To keep it simple, I’ll assume last year’s annual dividend payments are consistent. Warning: last year’s dividends are not always a good input to a DDM because dividends are not guaranteed since things can change quickly inside a business — and in the stockmarket. So far in 2020, the Big Banks have been cutting or deferring their dividends.
In any case, using my DDM we will assume the dividend payment grows at a consistent rate in perpetuity (i.e. forever), for example, at a yearly rate between 1.5% and 3%.
Next, we have to pick a yearly ‘risk’ rate to discount the dividend payments back into today’s dollars. The higher the ‘risk’ rate, the lower the share price valuation.
I’ve used a blended rate for dividend growth and a risk rate between 8% and 13%.
My DDM valuation of WBC shares is $22.48. The valuation compares to Westpac Banking Corp’s share price of $16.26.
Obviously, simple models like these are handy tools for analysing and valuing a bank share like Westpac Banking Corp.
That said, it’s far from a perfect valuation. And while no-one can ever guarantee a return, there are things you can (and probably should) do to improve the valuation before you consider it as a worthwhile yardstick.
For example, studying the growth of the loans on the balance sheet is a very important thing to do: if they’re growing too fast it means the bank could be taking too much risk; too slow and the bank might be too conservative. Then I’d study the remainder of the financial statements for risks.
Areas to focus on include the provisions for bad loans (income statement), their rules for assessing bad loans (accounting notes) and the sources of capital (wholesale debt markets or customer deposit). On the latter, take note of how much it costs the bank to get capital into its business to lend out to customers, keeping in mind that overseas debt markets are typically more risky than customer deposits due to exchange rates, regulation and the fickle nature of investment markets.