Our largest bank shares make up more than one-third of the local share market, measured by the market capitalisation of the largest 200 companies in the S&P/ASX 200 index.
If you really want to understand how to value a dividend share, like a bank or REIT, you should consider watching the tutorial video from the analyst team at Rask Australia.
Price-earnings sector valuation
If you have been investing in individual stocks or companies 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 straightforward 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 basic 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 too much, or cheap. 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 PE ratio (E x sector PE) to calculate what an average company would be worth.
If we take the NAB share price today ($27.74), 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 34.5x. That compares to the banking sector average PE of 21x.
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 $17.04.
Dividend models (a 101 walkthrough)
A DDM or dividend discount model is quite different from ratio valuations like PER because it makes you forecast cash flows into the future (it uses dividends as ‘cash flow’). Because the banking sector has proven to be relatively stable with regards to share dividends, the DDM approach can be used. However, we would not use this model for, say, technology shares.
Basically, we need only one input into a DDM model: dividends per share. Then, we make some assumptions about the yearly growth of the dividend (e.g. 2%) and the risk level of the dividend payment (e.g. 7%). We’ve used the most recent full year dividends (e.g. from last 12 months or LTM) then assumed the dividends remain consistent but grow slightly.
To make this DDM easy to understand, we will assume last year’s dividend payment ($0.60) rises 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 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 $27.74. 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 projection to $31.50.
It’s time for further research
Our two models could be used as an introductory guide for how the valuation process works. Analysing a bank share like National Australia Bank Ltd is a complicated task. If we were looking at the shares and considering an investment, we would first want to know more about the bank’s growth strategy. For example, are they pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc..
Next, take a close look at economic indicators like unemployment, house prices and consumer sentiment. Where are they headed? Finally, we believe it’s important to make an assessment of the management team. For example, when we pulled data on NAB’s culture we found that it wasn’t a perfect 5/5. Culture is one thing to think carefully about.