Generating a share price forecast for a bank/insurance share like Suncorp Group Ltd (ASX: SUN) is never a certainty. That said, a thorough research process and basic valuation can help you understand what’s going on under the hood of any a business.
Suncorp Group is an $11 billion insurance and banking company. It has its own brand of products but also operates under names like AAMI, GIO, Apia and Shannons. It also operates a regional banking division called Suncorp Bank.
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 mighty PE ratio
The PE ratio compares a company’s share price (P) to its yearly profit per share (E). ‘Earnings’ is another word for profit.
There are three easy ways to use the PE ratio. First, you can use ‘intuition’ and say ‘if it’s low, I’ll buy shares’ or ‘if it is above 40x, I’ll sell shares’ (whatever works for you).
Secondly, you can compare the PE ratio of a stock like SUN with MQG or the sector average. Is it higher or lower? Does it deserve to be more expensive or cheaper? Third, you can take the earnings/profits per share of the company you’re valuing and multiply that number by a PE multiple that you believe is appropriate. For example, if a company’s profit per share (E) was $5 and you believe the stock is ‘worth at least 10x its profit’ it would have a valuation, according to you, of $5 x 10 = $50 per share.
Using Suncorp Group Ltd’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 11x. This compares to the banking sector average of 10x.
Reversing the logic here, we can take the profits per share (EPS) ($0.788) and multiply it by the ‘mean average’ valuation for SUN. This results in a ‘sector-adjusted’ share valuation of $7.60.
Using a DDM model
As explained in the video above, taken from our free online share valuation course, 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 stock market. So far in 2020, Big Banks like NAB have been cutting or, in ANZ’s case, 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 SUN shares is $7.96. However, using an ‘adjusted’ dividend payment of $0.40 per share, the valuation drops to $4.55. The valuation compares to Suncorp Group’s share price of $8.70.
What now?
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 SUN. 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 Suncorp Group’s culture from Seek we found that the company got a 3.4 out of 5 for overall employee culture. No company has a perfect culture, 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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