As you may know, this is the rough version. Keep in mind, rough doesn’t necessarily equal ‘good’. So, at the bottom of this article, we’ll provide some further resources to complement our potential indicative valuations. Basically, it goes without saying but these valuations are not guaranteed.
Bank shares like National Australia Bank Ltd, Westpac Banking Corp (ASX: WBC) and ANZ Banking Group (ASX: ANZ) are highly popular in Australia because of their reliable dividend history, and the added value of franking credits.
In this article, we’ll cover the basics of investing in ASX bank shares. If you’re interested to learn more about the value of dividend investing in Australia (including how franking credits work), you might like to check out our free online investing courses.
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Using multiples
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 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 ($41.21), together with the earnings (aka profits) per share data from its FY24 financial year ($2.26), we can calculate the company’s PE ratio to be 18.2x. That compares to the banking sector average PE of 20x.
Next, take the profits per share (EPS) ($2.26) and multiply it by the average PE ratio for NAB’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $44.78.
Using NAB’s share dividend to arrive at a valuation
A DDM, which stands for Dividend Discount Model, is a more interesting and robust way of valuing companies in the banking sector, given that the dividends are pretty consistent.
DDM valuation modelling is one of the oldest methods used on Wall Street to value companies, and it’s still used here in Australia by bank analysts. 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 grow at a consistent rate for a forecast period (e.g. 5 years or forever). The only other number you need is a ‘risk’ rate (e.g. 7%) which is explained further below.
To do the valuation, use this formula: Share price = full-year dividend / (risk rate – dividend growth rate). It’s a good idea to do the calculation with a few different growth and risk assumptions, then take the average valuation. This helps to account for some of the uncertainty.
To simplify this DDM, we will assume last year’s dividend payment ($1.69) rises at a consistent rate each year.
Next, we determine the ‘risk’ rate or expected return rate. This is the rate at which we discount the future dividend payments back to today’s dollars. A higher ‘risk’ rate results in a lower share price valuation.
We’ve used a blended rate for dividend growth and a risk rate between 6% and 11%, then averaged the results.
This approach yields a valuation of NAB shares of $35.74. However, using an ‘adjusted’ dividend payment of $1.71 per share, the valuation goes to $36.16. The expected dividend valuation compares to National Australia Bank Ltd’s share price of $41.21.
Since the company’s dividends are fully franked, you could 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 ($2.44), our valuation of the NAB share price comes out at $51.66.
| Growth rate | ||||
| 2.00% | 3.00% | 4.00% | ||
|
Risk rate
|
6.00% | $42.75 | $57.00 | $85.50 |
| 7.00% | $34.20 | $42.75 | $57.00 | |
| 8.00% | $28.50 | $34.20 | $42.75 | |
| 9.00% | $24.43 | $28.50 | $34.20 | |
| 10.00% | $21.38 | $24.43 | $28.50 | |
| 11.00% | $19.00 | $21.38 | $24.43 | |
Takeaways for the NAB share price
Simple valuation models like these can be handy tools for analysing and valuing a bank share like National Australia Bank Ltd. These models can even make you feel warm and fuzzy inside because you have ‘put a value on it’.
That said, it’s far from a perfect valuation (as you can see). 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 instance, studying the growth or increase in total 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, study the remainder of the financial statements for risks.
Areas to focus on include the 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.
