Are Australia and New Zealand Banking Group Ltd (ASX: ANZ) shares worth just $18?
I’m going to show you the shortcut or easy version to put a valuation on a bank share, then provide some further resources and offer potential indicative valuations, using ANZ shares as my case study. I think it goes without saying but these valuations are not guaranteed.
Bank shares like Australia and New Zealand Banking GrpLtd, National Australia Bank Ltd. (ASX: NAB) and Commonwealth Bank of Australia (ASX: CBA) are very popular in Australia because they tend to have a stable dividend history, and often pay franking credits.
While I explain the basics of investing in bank shares in this article, if you’re interested in understanding the value of dividend investing in Australia, consider watching the video from the education team at Rask Australia.
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Using “comparables” to do a PE valuation
Chances are, if you have been actively investing in shares for more than a few years you will have heard about the PE ratio. The price-earnings ratio or ‘PER’ compares a company’s share price (P) to its most recent full-year earnings per share (E). If you bought a coffee shop for $100,000 and it made $10,000 of profit last year, that’s a price-earnings ratio of 10x ($100,000 / $10,000). ‘Earnings’ is just another word for profit. So, the PE ratio is basically saying ‘price-to-yearly-profit multiple’.
The PE ratio is a very simple tool but it’s not perfect so it should only be used with other techniques (see below) to back it up. That said, one of the simple ratio strategies even professional analysts will use to value a share is to compare the company’s PE ratio with its competitors to try to determine if the share is overvalued or undervalued. It’s akin to saying: ‘if all of the other banking sector stocks are priced at a PE of X, this one should be too’. We’ll go one step further than that in this article. We’ll apply the principle of mean reversion and multiply the profits per share (E) by the sector average PR ratio (E x sector PE) to calculate what an average company would be worth.
Using Australia and New Zealand Banking GrpLtd’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 6.7x. This compares to the banking sector average of 10x.
Reversing the logic here, we can take the profits per share (EPS) ($2.276) and multiply it by the ‘mean average’ valuation for ANZ. This results in a ‘sector-adjusted’ share valuation of $21.70.
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 valuation models used on Wall Street and even here in Australia. A DDM model uses the most recent full-year dividends (e.g. from 2019/2020) or forecast dividends for next year and then assumes the dividends remain consistent or grow slightly for the forecast period (e.g. 5 years or forever).
To keep it simple, I’ll assume last year’s annual dividend payments are consistent. 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 — and in the stockmarket. So far in 2020, the Big Banks have been cutting or deferring their dividends.
In any case, using my DDM we will assume the dividend payment grows at a consistent rate in perpetuity (i.e. forever), for example, at a yearly rate between 1.5% 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.
I’ve used a blended rate for dividend growth, and I’m using a risk rate between 9% and 14%.
My DDM valuation of ANZ shares is $18.20. However, using an ‘adjusted’ dividend payment of $1.20 per share, the valuation drops to $13.65. The valuation compares to Australia and New Zealand Banking GrpLtd’s share price of $15.29.
What to do next
Obviously, simple models like these are handy tools for analysing and valuing a bank share like Australia and New Zealand Banking GrpLtd.
That said, it’s far from a perfect valuation. And while no-one can ever guarantee a return, there are things you can (and probably should) do to improve the valuation before you consider it as a worthwhile yardstick.
For example, studying the growth of the loans on the balance sheet is a very important thing to do: if they’re growing too fast it means the bank could be taking too much risk; too slow and the bank might be too conservative. Then I’d study the remainder of the financial statements for risks.
Areas to focus on include provisions for bad loans (income statement), their rules for assessing bad loans (accounting notes) and the sources of capital (wholesale debt markets or customer deposit). On the latter, take note of how much it costs the bank to get capital into its business to lend out to customers, keeping in mind that overseas debt markets are typically more risky than customer deposits due to exchange rates, regulation and the fickle nature of investment markets.