ASX bank shares make up around one-third of the Aussie stock market, measured by the market cap and the All Ordinaries Index.
Within the financial sector, ASX bank shares are far and away the most popular. We will step through the absolute basics of valuing a bank share like Westpac Banking Corp. If you’re truly interested in understanding more about how to value a bank share, you should consider watching this tutorial from the analyst team at Rask Australia.
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WBC share price: inside the PE valuation
The price-earnings ratio, which is short for price-to-earnings, is a basic but popular valuation ratio. It compares yearly profit (or ‘earnings’) to today’s share price ($22.86). Unfortunately, it’s not the perfect tool for bank shares, so it’s vital 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 ($22.86), together with the earnings (aka profits) per share data from its 2023 financial year ($1.95), we can calculate the company’s PE ratio to be 11.7x. That compares to the banking sector average PE of 13x.
Next, take the profits per share (EPS) ($1.95) and multiply it by the average PE ratio for WBC’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $25.92.
Using a DDM for the better WBC share price
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).
To make this DDM easy to understand, we will assume last year’s dividend payment ($1.42) goes up at a fixed rate each year.
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 a blended rate for dividend growth and a risk rate between 6% and 11%, then got the average.
This simple DDM valuation of WBC shares is $27.07. However, using an ‘adjusted’ dividend payment of $1.40 per share, the valuation goes to $25.10. The expected dividend valuation compares to Westpac Banking Corp’s share price of $22.86. 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 ($2.00), our valuation of the WBC share price guesstimate to $35.85.
Keep going
You could consider using these models as the starting point for your process for analysing and valuing a bank share like WBC. However, please remember that these are just tools used by analysts and in reality, a good analyst and investor will likely conduct 100+ hours of qualitative research before diving into their spreadsheet and starting their modelling.
For example, we spend a lot of our time looking at bank shares and writing about them, but if we were thinking about investing in a bank today we would want to get a handle on its growth strategy, economic indicators like unemployment, and then study house prices and consumer sentiment.
