Below I’ll walk you through two tools an ASX investment analyst would use to provide share price ‘target’ on a company like National Australia Bank Ltd. (ASX:NAB).
Obviously, I’m going to show you the shortcut or easy version, then provide some further resources and offer potential indicative valuations, using NAB shares as my case study. I think it goes without saying but these valuations are not guaranteed.
Bank shares like National Australia Bank Ltd., Westpac Banking Corp (ASX:WBC) and ANZ Banking Group (ASX:ANZ) 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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Reversing the PE ratio
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 10.7x. This compares to the banking sector average of 11x.
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 $19.59.
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Wall Street’s oldest valuation model
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 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 $18.59.
Obviously, simple models like these are handy tools for analysing and valuing a bank share like National Australia Bank Ltd..
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.