Wouldn’t it be handy to know how an analyst values ASX bank shares like Westpac Banking Corp (ASX:WBC) shares? With the WBC share price trading around $26.23, is it cheap?
No one can tell you for certain whether now is the perfect time to buy.
In the short run, the share market can seem like a random place. It can be up 2% one day, down 3% the next. There’s often no rhyme or reason (although pundits are paid the big bucks for the evening news to make you think they have a crystal ball).
In this article, we’ll go step-by-step through two key valuation tools you can use to value a share like WBC or even Bank of Queensland Limited (ASX:BOQ) and National Australia Bank Ltd (ASX:NAB).
But before we dive in, it’s worth mentioning why ASX bank shares are so tempting right now (and have been popular since the early 1990s). The answer is surprisingly simple: falling interest rates and a recession-less economy (until 2020, of course). In the early 90s, Australia began a once-in-a-generation unwinding of interest rates. Rates fell from over 15% to near-zero by 2020. Banks, with their exposure to property prices, more savings and, of course, more household debt, were the obvious beneficiary of this structural shift.
Keep in mind, ASX bank shares are not without their risks, and nothing is ever guaranteed in the share market. Further still, bank shares like WBC or BOQ often appear undervalued, at least on a PE basis, since they are highly regulated, tend to experience slower profit growth, pay more of their profit in dividends and are typically ‘mature’ businesses.
Picking a PE
The price-earnings ratio, which is short for price-to-earnings, is the simplest and most popular valuation ratio. It compares yearly profit (or ‘earnings’) to today’s share price ($26.23). Unfortunately, it’s not the perfect tool for bank shares, so it’s good to use more than just PE ratios for your analysis.
That said, it can be handy to compare PE ratios across shares from the same sector (banking) and determine what is reasonable — and what isn’t.
If we take the WBC 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 41.2x. That compares to the banking sector average PE of 25x.
We can take the profits per share (EPS) ($0.637) and multiply it by the average valuation for WBC. This results in a ‘sector-adjusted’ share valuation of $16.17.
WBC DDM valuation
A DDM is a more interesting and robust way of valuing companies in the banking sector, given that the dividends are pretty consistent.
DDM valuation modeling is one of the oldest methods used on Wall Street to value companies, and it’s still used here in Australia by bank analysts. 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 grow at a consistent rate for a forecast period (e.g. 5 years or forever).
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 WBC shares is $5.91. However, using an ‘adjusted’ dividend payment of $1.07 per share, the valuation goes to $19.18. The valuation compares to Westpac Banking Corp’s share price of $26.23.
Don’t stop here
Make sure you don’t forget that the two models used here are only the starting point of the process for analysing and valuing a bank share like WBC.
We think it’s good practice to read at least three years of annual reports, jot down your thoughts/research and set out your thesis/expectations based on what management is saying. Indeed, a very useful tool is studying management’s language in presentations and videos. Is the management team candid? Or does he/she use lots of jargon and never answer a straight question? Finally, read articles and research from good analysts, and when you do, seek out people who disagree with you. These voices are often the most important.
These are are just a handful of the best strategies to use alongside your valuation tools to determine if you’re making a mistake — hopefully, before you make a costly mistake!
