A question many investors ask themselves is, how much are Westpac Banking Corp (ASX:WBC) shares really worth?
This is one of the most common questions 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 offer 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’, foreign competitors’ success has been very limited.
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 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 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.
Using WBC’s share price today, together with the earnings per share data from its 2020 financial year, we can calculate the company’s PE ratio to be 39.6x. That compares to the banking sector average PE of 25x.
Reversing the logic here, we can take the profits per share (EPS) ($0.637) and multiply it by the ‘mean average’ valuation for WBC. This results in a ‘sector-adjusted’ share valuation of $15.71.
The absolute value of dividends
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.
For simplicity, let’s assume last year’s dividend payments are consistent. Important warning: last year’s dividends are not always a good input to a DDM because dividends are not guaranteed since things can change quickly inside a business. So far in 2020, Australia’s Big Banks have been cutting or deferring their dividends.
To make this easy to understand, using our DDM we will assume the dividend payment grows at a consistent rate in perpetuity (i.e. forever) at a yearly rate between 2% and 3%.
Next, we have to pick a yearly ‘risk’ rate to discount the 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 $25.21.
Key takeaways
These two share valuation models 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 were 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 important to make an assessment of the management team.
