Australia and New Zealand Banking GrpLtd (ASX:ANZ) shares – are they cheap?

Is it time to buy, hold or sell Australia and New Zealand Banking GrpLtd (ASX:ANZ) shares?

This is one of the most common questions that our senior investment analysts get asked by Australian investors seeking dividend income. It’s not exclusive to Australia and New Zealand Banking GrpLtd, of course.

National Australia Bank Ltd. (ASX:NAB) and Commonwealth Bank of Australia (ASX:CBA) are also very popular stocks on the ASX.

Before I provide you with two valuation models you might use to answer the valuation question yourself, let’s consider why investors like bank shares in the first place.

Alongside the ASX technology and healthcare sectors, bank shares are a favourite for Australian investors. The largest banks, including Commonwealth Bank of Australia and National Australia Bank operate in an ‘oligopoly’. And while large international banks (I’m looking at you, HSBC) have tried to muscle in on our ‘Big Four’, foreign competitors’ success has been very limited.

Tired of the same ol' dividend stocks?

Using “comparables” to do a PE valuation

Chances are, if you have been actively investing in shares for more than a few years you will have heard about the PE ratio. The price-earnings ratio or ‘PER’ compares a company’s share price (P) to its most recent full-year earnings per share (E). If you bought a coffee shop for $100,000 and it made $10,000 of profit last year, that’s a price-earnings ratio of 10x ($100,000 / $10,000). ‘Earnings’ is just another word for profit. So, the PE ratio is basically saying ‘price-to-yearly-profit multiple’.

The PE ratio is a very simple tool but it’s not perfect so it should only be used with other techniques (see below) to back it up. That said, one of the simple ratio strategies even professional analysts will use to value a share is to compare the company’s PE ratio with its competitors to try to determine if the share is overvalued or undervalued. It’s akin to saying: ‘if all of the other banking sector stocks are priced at a PE of X, this one should be too’. We’ll go one step further than that in this article. We’ll apply the principle of mean reversion and multiply the profits per share (E) by the sector average PR ratio (E x sector PE) to calculate what an average company would be worth.

Using Australia and New Zealand Banking GrpLtd’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 6.7x. This compares to the banking sector average of 10x.

Reversing the logic here, we can take the profits per share (EPS) ($2.276) and multiply it by the ‘mean average’ valuation for ANZ. This results in a ‘sector-adjusted’ share valuation of $21.63.

Free report: Our expert just named 3 growth stocks for 2020

rask invest stocks to buy now

Dividends matter

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 ANZ shares is $18.20. However, using an ‘adjusted’ dividend payment of $1.20 per share, the valuation drops to $13.65. The valuation compares to Australia and New Zealand Banking GrpLtd’s share price of $15.23.

What to do next

These two models are just the starting point of the research and valuation process. Banks are very complex companies and if the Global Financial Crisis (GFC) — see Lehman Brothers — taught us anything, it’s that even the ‘best’ banks can go out of business and take shareholders with them!

If I were looking at Australia and New Zealand Banking GrpLtd shares and considering an investment, I’d want to know more about the bank’s growth strategy. For exmaple, are they pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc.). Then, I’d take a close look at economic indicators such as unemployment, house prices and consumer sentiment. Finally, it’s always important to make an assessment of the management team.

If you're looking for more ETF and expert ASX investment insights, you should consider grabbing a copy of our latest investment report. It's called "3 stocks for the cloud revolution". Hundreds of Australian investors have already accessed this report in the last month alone.

The report is available right now and it's 100% free, when you create a free Rask Australia account. Simply click here now to access the report and loads of other free benefits.

feedback-icon

What can we do better? Leave us some feedback?

We care about your experience, please let us know if you have any suggestions to improve our site.