Are National Australia Bank Ltd. (ASX:NAB) shares dirt cheap, cheap, fair value, seriously overvalued… or none of the above?
Of course, no-one can tell you for sure. We know that. You know that.
The share market can seem like a random place at the best of times.
However, in this short article I’ll go step-by-step through two key valuation tools you can use to value a share like NAB or even Westpac Banking Corp (ASX:WBC) and Australia and New Zealand Banking GrpLtd (ASX:ANZ).
Before I get to that, I think it’s easy to see why bank shares have been very popular since the early 1990s, when Australia began a once-in-a-generation unwinding of interest rates (from over 15%!), our population began to rise quickly and consistently, and the resources and housing booms took flight. Banks were obvious beneficiaries of these structural trends.
That said, bank shares are definitely not without their risks and nothing is ever gauranteed in the stock market. What’s more, bank shares like NAB or WBC often appear undervalued (on a price-earnings basis) because they are highly regulated, tend to experience slower growth, pay more of their profit in dividends and they are, generally speaking, mature businesses.
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Using profits to valuation shares
The price-earnings ratio or ‘PE’ compares a company’s share price (P) to its most recent full-year earnings per share (E). Remember, ‘earnings’ is just another word for profit. That means, the PE ratio is simply comparing share price to the most yearly profit of the company. Some experts will try to tell you that ‘the lower PE ratio is better’ because it means the share price is ‘low’ relative to the profits produced by the company. However, sometimes shares are cheap for a reason!
Secondly, some extremely successful companies have gone for many years (a decade or more) and never reported an accounting profit — so the PE ratio wouldn’t have worked.
Therefore, I think it’s very important to dig deeper than just looking at the PE ratio and thinking to yourself ‘if it’s below 10x, I’ll buy it.’
One of the simple ratio models analysts use to value a bank share is to compare the PE ratio of the bank/share you’re looking at with its peer group or competitors and try to determine if the share is over-valued or under-valued relative to the average. From there, and using the principle of mean reversion, we can multiply the profits/earnings per share by the sector average (E x sector PE) to reflect what an average company would be worth. It’s like saying, ‘if all of the other stocks are priced at ‘X’, this one should be too’.
Using NAB’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 8.8x. This compares to the banking sector average of 10x.
Reversing the logic here, we can take the profits per share (EPS) ($1.739) and multiply it by the ‘mean average’ valuation for NAB. This results in a ‘sector-adjusted’ share valuation of $16.52.
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The value of dividends
Since bank shares like NAB have a history of paying dividends — and they are relatively stable businesses like REITs or ETFs — we can use a modelling tool called a dividend discount model or DDM to do a valuation.
A DDM uses the dividends shareholders are ‘expected’ to receive to arrive at a valuation.
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 NAB shares is $18.88. However, using an ‘adjusted’ dividend payment of $1.10 per share, the valuation drops to $12.51. The valuation compares to National Australia Bank Ltd.’s share price of $15.34.
Obviously, the two models I used here are only the starting point of the process for analysing and valuing a bank share like NAB.
I think it’s good practice to read at least three years of annual reports, write down your thoughts and set your thesis/expectations based on what management is saying. Study management’s language in presentations and videos (are they candid or do they use lots of jargon?), read articles and research from good analysts, and seek out people who disagree with you.
Those are just some of the best strategies to use alongside your valuation tools to determine if you’re making a mistake — before you do it!
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