Even if you’re professional investment analyst, formulating a share price forecast for a share like Bendigo and Adelaide Bank Ltd (ASX:BEN) is never a certainty. That said, a thorough valuation will help you understand what’s going on under the hood.
Australia’s large bank shares make up over 40% of the share market, measured by the market capitalisation and inclusion in the S&P/ASX 200 index.
It’s easy to see why bank shares have been so popular since the early 1990s, when Australia had its last official recession — and mortgage interest rates were over 15%!
One great thing about banks is that, for the most part, they are ‘implicitly’ protected from complete financial collapse or bankruptcy because a bank going out of business would be a political nightmare. That said, as we’ve seen recently, shareholder returns are never guaranteed.
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 BEN’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 9.4x. This compares to the banking sector average of 11x.
Reversing the logic here, we can take the profits per share (EPS) ($0.764) and multiply it by the ‘mean average’ valuation for BEN. This results in a ‘sector-adjusted’ share valuation of $8.76.
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Dividends plus growth
Since bank shares like BEN 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 BEN shares is $7.51. However, using an ‘adjusted’ dividend payment of $0.40 per share, the valuation drops to $4.55. The valuation compares to Bendigo and Adelaide Bank Ltd’s share price of $7.19.
I think it goes without saying that these two models are only the starting point of the process for analysing and valuing a bank share like BEN. If I were looking at the shares and considering an investment, I’d want to know more about the bank’s growth strategy. Are the net interest margins holding up if they are pursuing more lending (i.e. interest income)? How are they dealing with regulation if they seek more non-interest income (fees from financial advice, investment management, etc.)?
Finally, it’s always important to make an assessment of the management team. For example, when we pulled data on Bendigo and Adelaide Bank Ltd’s culture we found that it wasn’t a perfect 5/5. No company has a perfect cutlure, of course. However, culture is one thing we think about a lot when analysing companies to buy and hold over the very long-term (10+ years).
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