On the Australian share market, National Australia Bank Ltd (ASX: NAB) shares are amongst the most traded, along with other bank shares like Westpac Banking Corp (ASX: WBC) and ANZ Banking Group (ASX: ANZ). The NAB share price is currently trading around $28.63.
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 National Australia Bank Ltd. 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.
Reversing the PE ratio for valuations
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 NAB with ANZ 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 NAB share price today ($28.63), together with the earnings (aka profits) per share data from its 2020 financial year ($0.805), we can calculate the company’s PE ratio to be 35.6x. That compares to the banking sector average PE of 23x.
Next, take the profits per share (EPS) ($0.805) and multiply it by the average PE ratio for NAB’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $18.49.
The stockbroker’s first valuation tool: the dividend model
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 ($0.60) rises 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 NAB shares is $11.44. However, using an ‘adjusted’ dividend payment of $1.23 per share, the valuation goes to $22.05. The expected dividend valuation compares to National Australia Bank Ltd’s share price of $28.63. 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 ($1.76), our valuation of the NAB share price calculation to $31.50.
You could consider using these models as the starting point for your process for analysing and valuing a bank share like NAB. 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.