Knowing what is — or isn’t — a good price to pay for a company like Macquarie Group Ltd (ASX: MQG) isn’t easy — especially in the current environment with COVID-19 and other economic uncertainties. Below, I’ll explain what to look at for a bank share such as MQG.
What does Macquarie do?
Macquarie Group is Australia’s largest investment bank with operations spread throughout North America, Europe, Middle East, Asia and Australia. Unlike a traditional ‘retail’ bank like, say, Commonwealth Bank of Australia (ASX: CBA) or Westpac Banking Corp (ASX: WBC), most investment banks such as Macquarie make a large chunk of their profit by providing services to clients in investment markets and managing ‘assets’ for individuals and organisations. As of 2019, Macquarie had reported a profit for 50 years in a row.
Here are five things to think about before you buy, hold or sell Macquarie shares
Focus on culture
Employee satisfaction is more than just a corporate trick to hook talented millennials. Good workplace culture leads to improved retention of high-quality staff and that ultimately determines the long-term success of an investment bank which relies on smart salespeople (also called investment bankers).
One way Australian investors can ‘look inside’ a company like Macquarie is to use Seek company reviews data. According to the most recent data pulled on the company, it’s overall workplace culture rating of 3.2/5 was in line with the major banking sector average.
Lending profits
Banks like MQG need good margins to make their lending model profitable. In basic terms, a bank will take money from term deposit holders and ‘wholesale debt investors’ to lend that money out to homeowners, businesses and investors. The difference or ‘spread’ between what a bank pays to savers and what it earns from mortgage holders (for example) is called the net interest margin or NIM. When it comes to NIMs, the wider the margin, the better.
When you’re forecasting profits and dividends for a bank like MQG or Bendigo and Adelaide Bank Ltd (ASX: BEN) into the future, knowing how much the bank lends and what it makes per dollar lent is essential. That’s why the NIM is arguably the most important measure of a bank’s profitability. Across all of the ASX’s major banks (8 in total), we calculated the average NIM was 2.01% whereas the MQG’s lending margin was 2.24%. Meaning, the Macquarie was able to produce a better-than-average return from lending money to customers versus its peers.
Return on equity
Return on equity or just ‘ROE’ compares the yearly profit of a bank against its total shareholder equity as shown on its balance sheet. The higher the ROE the better. Macquarie’s ROE in the latest full-year stood at 16.2%, meaning for every $100 of shareholder equity in the bank it produced $16.20 in yearly profit. This was over and above the banking sector average of 10.4%.
Capital structure
When it comes to banking risk management the CET1 ratio (common equity tier one) is paramount. CET1 represents the bank’s ‘safety capital’ or ‘buffer’ to protect against financial collapse. In the most recent full year, Macquarie Group had a CET1 ratio of 11.4%. This was higher than the sector average and, in my opinion, probably sits above APRA’s ‘unquestionably strong’ level.
Dividends & valuations
In the video above (part of our free valuation course), I explain how to do a DDM valuation on any blue-chip dividend share, like Woolworths or Macquarie.
A DDM or dividend discount model is one of the best ways to value a bank’s shares. To do a DDM we have to estimate the bank’s dividends going forward and apply a risk rating. Using a simple DDM, let’s assume the bank’s dividend payment grows at a steady rate into the future (i.e. forever) somewhere between 1.5% and 3%. For the risk rating, we will use risk rates between 9% and 14%. Then we will average the valuations.
And the result? Our simple average DDM valuation of MQG shares is $69.38. However, using an ‘adjusted’ dividend payment of $4 per share, the valuation goes to $45.49. The valuation compares to MQG’s current share price of $110.49 — that is, depending on how you value the bank and your dividend input, the shares could be priced well above the dividend valuation.
However, although the shares might seem expensive using our simple DDM model, don’t make a decision based on this article — there’s so much more that goes into making a sound investment decision. Please go away now and consider all of the risks and ideas we presented here. While you’re at it, you might also consider a diversified shares ETF, dividend fund or at least grab a copy of our free investment report below.
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