In this short article, I’ll explain how simple it can be to provide a valuation of a bank share such as Suncorp Group Ltd (ASX:SUN). However, while it may seem ‘simple’ to create a valuation model of a company, no share valuation is gauranteed. If ‘value investing’ were as easy as I’m about to show you, everyone — including me — would be a millionaire!
Our largest bank shares make up nearly half of the local share market, measured by the market capitalisation of the largest 200 companies in the S&P/ASX 200 index.
If you really want to understand how to value a dividend share, like a bank or REIT, you should consider watching the tutorial video from the analyst team at Rask Australia.
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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 SUN with MQG 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 Suncorp Group Ltd’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 11.3x. This compares to the banking sector average of 10x.
Reversing the logic here, we can take the profits per share (EPS) ($0.788) and multiply it by the ‘mean average’ valuation for SUN. This results in a ‘sector-adjusted’ share valuation of $7.83.
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Dividends plus growth
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 I’m using a risk rate between 9% and 14%.
My DDM valuation of SUN shares is $7.96. However, using an ‘adjusted’ dividend payment of $0.4 per share, the valuation drops to $4.55. The valuation compares to Suncorp Group Ltd’s share price of $8.89.
These two models could be used a guide to the valuation process and analysing a bank share like Suncorp Group Ltd. If I were looking at the shares and considering an investment, I’d first want to know more about the bank’s growth strategy. For example, are they pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc..
Next, I’d take a close look at economic indicators like unemployment, house prices and consumer sentiment. Where are they headed? Finally, it’s always important to make an assessment of the management team. For example, when we pulled data on SUN’s culture we found that it wasn’t a perfect 5/5. Culture is one thing to think carefully about.