How much are National Australia Bank Ltd. (ASX:NAB) shares worth?
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 National Australia Bank Ltd., of course.
Before we 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 tech and industrial sectors, the financials/banking industry is 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, such as HSBC, have tried to encroach on our ‘Big Four’, foreign competitors’ success has been very limited
The price-earnings 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, we 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, together with the earnings per share data from its 2019/2020 financial year, we can calculate the company’s PE ratio to be 10.7x. That compares to the banking sector average PE of 16x.
Reversing the logic here, we can take the profits per share (EPS) ($1.74) and multiply it by the ‘mean average’ valuation for NAB. This results in a ‘sector-adjusted’ share valuation of $27.91
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The true worth dividends
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 by stock market analysts. A DDM model uses the most recent full-year dividends (e.g. from last 12 months or LTM) 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).
For simplicity, let’s assume last year’s dividend payments are consistent. Important 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. So far in 2020, Australia’s Big Banks have been cutting or deferring their dividends.
To make this easy to understand, using our DDM we will assume the dividend payment grows at a consistent rate in perpetuity (i.e. forever) 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. We’ve used an average rate for dividend growth and a risk rate between 7% and 12%.
This simple DDM valuation of NAB shares is $16.93. However, using an ‘adjusted’ dividend payment of $0.81 per share, the valuation drops to $12.14. The valuation compares to National Australia Bank Ltd.’s share price of $18.70.
Next steps from here
These two share valuation models are just the starting point of the research and valuation process. Banks are very complex companies and if the GFC of 2008/2009 taught investors anything, it’s that even the ‘best’ banks can go out of business and take shareholders with them!
If you are were looking at National Australia Bank Ltd. shares and considering an investment, take your time to learn more about the bank’s growth strategy. For example, is it pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc.)? Next, 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.
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