ASX bank shares rocket higher but are shares like ANZ still cheap?

ASX bank shares have pushed the ASX 200 higher today as the market reacts to extra Chinese stimulus, more positive share market momentum, the government’s new JobMaker program, and rising expectations of a return to normal.

Australia and New Zealand Banking Group Ltd (ASX: ANZ) shares are one the ASX leaders today (up 4.6%), but it’s not alone. National Australia Bank Ltd. (ASX: NAB) rose 4%, Commonwealth Bank of Australia (ASX: CBA) jumped 1.6% and Westpac Banking Group (ASX: WBC) rallied 5% in afternoon trade on Tuesday.

Given the renewed optimism in bank shares and the economy, let’s ask ourselves what bank shares like ANZ would be worth right now — in light of its deferred dividend payment. I’ll be using a DDM model for this valuation.

DDM valuation modelling explained

ANZ share valuation

A dividend discount model or DDM is the most 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).

Using my DDM model, we will assume ANZ’s dividend payment grows at a consistent rate in perpetuity (i.e. forever), for example, at a yearly rate between 1.5% and 3%.

We also have to pick a yearly ‘risk’ rate to discount the future dividend payments back into today’s dollars. The higher the ‘risk’ rate, the lower the share price valuation. For my simple model, 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, this assumes last year’s dividend is paid this year. Using an ‘adjusted’ dividend payment of $1.20 per share, the valuation drops to $13.65. The valuation compares to ANZ’s current share price of $16.35. So, under the assumption, it pays a yearly dividend of $1.20 (and we don’t consider the benefit of franking credits), my simple DDM model suggests ANZ shares are overvalued at current prices.

What now?

My basic model is just the starting point of the research and valuation process. Banks are very complex companies and if the Global Financial Crisis (GFC) taught us anything it’s that even the ‘best’ banks can go out of business and take shareholders with them. As I said last week, I’d probably consider CBA shares over ANZ shares.

However, if my only goal was reliable dividend income I’d probably consider a dividend ETF like Vanguard VHY or a simple market capitalisation index fund ETF like BetaShares A200 or Vanguard VAS first.

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