Right now, you could probably use Google or another data provider to see the price of ANZ Banking Group (ASX:ANZ) is around $28.69 per share. But what are ANZ shares really worth?

Valuation is one of the more popular questions our senior investment analysts get asked by Australian investors, especially those seeking dividend income. It’s not exclusive to ANZ Banking Group, of course.

National Australia Bank Ltd (ASX:NAB) and Commonwealth Bank of Australia (ASX:CBA) are also very popular stocks on the ASX.

Before we walk through 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’, the success of foreign competitors has been very limited. In Australia, ASX bank shares are particularly favoured by dividend investors looking for franking credits.

Getting a price on profit (PE ratio)

The PE ratio compares a company’s share price (P) to its yearly 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 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 ANZ with CBA 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.

If we take the ANZ share price today, together with the earnings (aka profits) per share data from its 2020 financial year, we can calculate the company’s PE ratio to be 23.7x. That compares to the banking sector average PE of 25x.

We can take the profits per share (EPS) ($1.21) and multiply it by the average valuation for ANZ. This results in a ‘sector-adjusted’ share valuation of $30.15.

What are ANZ dividends worth?

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 proper valuation models used by professional analysts or brokers on Wall Street (note: just because they’re old doesn’t make them ‘good’). A DDM model takes 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 for the forecast period.

Let’s assume last year’s dividend payments are consistent over time. Please note that using dividends paid last year is not always a good input to a DDM since the future is what we care about (note: we’ve made adjustments below to handle this).

To make the DDM easy to understand, we will assume the dividend payment grows at a consistent rate into the future (i.e. forever) at a fixed yearly rate.

Next, we have to pick a ‘risk’ rate or expected return rate to discount the future 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 6% and 11%.

This simple DDM valuation of ANZ shares is $11.44. However, using an ‘adjusted’ dividend payment of $1.22 per share, the valuation goes to $21.87. The valuation compares to ANZ Banking Group’s share price of $28.69.

What now?

Please be mindful that these valuation methods are just the starting point of the research and valuation process. Please remember that. 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 down with them.

If you are looking at ANZ Banking Group 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.)? Then, 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.