As you may know, this is the standard version. Keep in mind that standard does not necessarily mean “good”. So, at the bottom of this article, we will provide additional resources to supplement our potential indicative valuations. Basically, it goes without saying but these valuations are not guaranteed.
Bank stocks like Westpac Banking Corp, Bank of Queensland Limited (ASX:BOQ) and National Australia Bank Ltd (ASX:NAB) are very popular in Australia as they tend to have a stable dividend history and often pay postage credits.
In this article, we will explain the basics of investing in ASX bank stocks. But if you want to understand the value of dividend investing in Australia (i.e. the benefits of franking credits), check out this video from the education team at Rask Australia.
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Choose a PE
The PE ratio compares a company’s share price (P) to its annual earnings per share (E) (note: “earnings” is another word for profit).
There are three easy ways to quickly use the PE ratio. First, you can use “intuition” and say “if it’s low, I’ll buy stocks” or “if it’s above 40x, I’ll sell stocks” (which works for you) .
Second, you can compare the PE ratio of a stock like WBC with NAB or the industry average. Is it higher or lower? Does it deserve to be more or less expensive? Third, you can take the earnings/earnings per share of the company you are valuing and multiply that number by whatever PE multiple you think is appropriate. For example, if a company’s earnings per share (E) were $5 and you believe the stock is “worth at least 10 times its earnings”, it would have a valuation, you believe, of $5 x 10 = $50 per share.
If we take WBC’s stock price today ($22.34), along with earnings (i.e., earnings) per share data for its fiscal year 2020 ($0.637), we we can calculate the company’s PE ratio at 35.1x. This compares to the banking industry average PE of 23x.
Next, take earnings per share (EPS) ($0.637) and multiply it by the average PE ratio for the WBC (Banking) sector. This translates to a “sector-adjusted” PE valuation of $14.74.
WBC DDM valuation
A Dividend Discount Model or “DDM” is a more robust method of valuing companies in the banking sector.
DDM valuation models are among the oldest proper valuation models used by professional analysts or brokers on Wall Street (note: just because they’re old doesn’t mean they’re “good”). A DDM model takes the most recent full year dividends (e.g. last 12 months or LTM), or the dividends forecast for the next year, then assumes that dividends remain constant or increase for the forecast period.
To make this DDM easier to understand, we will assume that last year’s dividend payment ($0.89) increases at a fixed rate each year.
Then we choose the “risk” rate or the expected rate of return. This is the rate at which we discount future dividend payments into today’s dollars. The higher the “risk” rate, the lower the stock price valuation.
We used a blended rate for dividend growth and a risk rate between 6% and 11%, then got the average.
This simple DDM valuation of WBC stock is $16.97. However, using an “adjusted” dividend payment of $1.25 per share, the valuation jumps to $22.41. The expected dividend valuation compares to Westpac Banking Corp’s share price of $22.34. Since the company’s dividends are fully franked, you may choose to make an additional adjustment and make the valuation on the basis of a “gross” dividend payment. That is, cash dividends plus franking credits (available to eligible shareholders). Using the expected gross dividend payment ($1.79), our estimate of the WBC stock price calculation is $32.01.
don’t stop here
Simple valuation models like these can be handy tools for analyzing and valuing a bank stock like Westpac Banking Corp. And although these models may even make you feel warm and fuzzy inside because you “put a value on it”.
That said, it’s far from a perfect valuation (as you can see). While no one can ever guarantee a return, there are things you can (and probably should) do to improve the rating before you consider it a valid benchmark.
For example, studying the growth or increase in total loans on the balance sheet is a very important thing to do: if they are growing too fast, it means that the bank could be taking on too much risk; too slow and the bank might be too conservative. Next, study the rest of the financial statements for risks.
Areas to focus on include provisions for bad debts (income statement), their bad debt valuation rules (accounting notes), and sources of capital (wholesale debt markets or customer deposit). On this last point, note how much it costs the bank to get capital into its business to lend to customers, bearing in mind that overseas debt markets are generally riskier than deposits from clients due to currency exchange rates, regulations and the volatile nature of investment markets.