Australia and New Zealand Banking GrpLtd (ASX:ANZ) shares are amongst the most traded, along with other bank stocks like National Australia Bank Ltd. (ASX:NAB) and Commonwealth Bank of Australia (ASX:CBA).
ASX bank shares make up nearly half of the market, measured by the market cap and the All Ordinaries Index.
I’m about to go through the absolute basics of valuing a stock like Commonwealth Bank of Australia.If you’re truly interested in understanding more about how to value a bank share, you should consider watching this tutorial from the analyst team at Rask Australia.
You can subscribe to the Rask Australia YouTube channel and receive the latest (and free) value investing videos by clicking here.
The price-earnings ratio
Chances are, if you have been actively investing in shares for more than a few years you will have heard about the PE ratio.
The price-earnings ratio or ‘PER’ compares a company’s share price (P) to its most recent full-year earnings per share (E). If you bought a coffee shop for $100,000 and it made $10,000 of profit last year, that’s a price-earnings ratio of 10x ($100,000 / $10,000). ‘Earnings’ is just another word for profit. So, the PE ratio is basically saying ‘price-to-yearly-profit multiple’.
The PE ratio is a very simple tool but it’s not perfect so it should only be used with other techniques (see below) to back it up. That said, one of the simple ratio strategies even professional analysts will use to value a share is to
compare the company’s PE ratio with its competitors to try to determine if the share is overvalued or undervalued. It’s akin to saying: ‘if all of the other banking sector stocks are priced at a PE of X, this one should be too’. We’ll go one step further than that in this article. We’ll apply the principle of mean reversion and multiply the profits per share (E) by the sector average PR ratio (E x sector PE) to calculate what an average company would be worth.
Using Australia and New Zealand Banking Group’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 6.9x. This compares to the banking sector average of 10x.
Reversing the logic here, we can take the profits per share (EPS) ($2.276) and multiply it by the ‘mean average’ valuation for ANZ. This results in a ‘sector-adjusted’ share valuation of $21.83.
The true worth dividends
A dividend discount model or DDM is different to ratio valuation like PE because it makes forecasts into the future, and uses dividends. Because the banking sector has proven to be relatively stable with regards to share dividends, the DDM approach can be used. However, we would not use this model for, say, technology shares.
Basically, we need only one input into a DDM model: dividends per share. Then, we make some assumptions about
the yearly growth of the dividend (e.g. 2%) and the risk level of the dividend payment (e.g. 7%). I’ve used the most recent full-year dividends (e.g. from 2019/2020) then assumed the dividends remain consistent but grow slightly.
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 a risk rate between 8% and 13%.
Using last year’s dividend payments of $2.27, my DDM valuation of ANZ shares is around $27. However, given ANZ’s decision to defer dividend payments, if I forecast dividends for the next 12 months at, say, $1.50, my DDM valuation drops to around $19. The valuation compares to ANZ’s share price of $15.75.
What now?
This article was not an attempt to tell you if ANZ shares are cheap or not.
Indeed, feel free to use these two models as the starting point for your process for analysing and valuing a bank share like ANZ. However, remember that these are just tools used by analysts and in reality a good analyst and investor will likely conduct 100+ hours of qualitative research before diving into their spreadsheet and starting their modelling.
For example, I spend a lot of my time looking at bank shares and writing about them, but if I were thinking about investing in a bank today I’d want to get a handle on its growth strategy, economic indicators like unemployment, and then study house prices and consumer sentiment.
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This article was written by Kathy Smithers, a staff writer for Best ETFs Australia.
