Right now, you could probably use Google or another data provider to see the price of Westpac Banking Corp (ASX: WBC) is around $27 per share. But what are WBC shares really worth?

Getting to an analyst valuation is one of the more popular questions or topics our senior investment analysts get asked by Australian investors, especially those seeking dividend income. It’s not exclusive to Westpac Banking Corp, of course.

Bank of Queensland Limited (ASX: BOQ) and National Australia Bank Ltd (ASX: NAB) are also very popular stocks on the ASX.

Before we walk through two valuation models you might use to answer the 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.

Doing a ‘Comps’ valuation

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 simple 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 WBC with NAB 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 WBC share price today ($26.63), together with the earnings (aka profits) per share data from its 2020 financial year ($0.637), we can calculate the company’s PE ratio to be 41.8x. That compares to the banking sector average PE of 26x.

Next, take the profits per share (EPS) ($0.637) and multiply it by the average PE ratio for WBC’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $16.45.

What are dividends actually 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.

To make this DDM easy to understand, we will assume last year’s dividend payment ($0.31) goes up at a consistent rate into the future at a fixed yearly rate.

Next, we pick the ‘risk’ rate or expected return rate. This is the rate at which we discount the future dividend payments back to 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 expected dividend valuation compares to Westpac Banking Corp’s share price of $26.63. Since the company’s dividends are fully franked, you might choose to make one further adjustment and do the valuation based on a ‘gross’ dividend payment. That is, the cash dividends plus the franking credits (available to eligible shareholders). Using the forecast gross dividend payment ($1.53), our valuation of the WBC share price calculation to $27.40.

Key takeaways – what to do from here

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 Westpac Banking Corp 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 vital to make an assessment of the management team.