As you can tell, this is the standard version. Keep in mind, quality does not necessarily equal ‘good’. So, at the end of this article, we will provide some more resources to supplement our potential indicator prices. Basically, it goes without saying that these prices are not guaranteed.
Bankshares such as Westpac Banking Corporation, BANK OF QUEENSLAND LIMITED (ASX: BOQ) and NATIONAL AUSTRALIA BANK LIMITED (ASX: NAB) are extremely popular in Australia due to their reliable dividend history, and the added value of franking credits.
In this article, we will cover the basics of investing in ASX bank shares. If you are interested in learning more about the value of dividend investing in Australia (including how franking credits work), you may want to check out our free online investment courses.
For access to our diagnostic models, videos and tutorials, consider subscribing to the Rask Australia YouTube channel. You’ll receive the latest (and free) value investing videos from our analysts. Click here to subscribe.
Using the PE ratio for prices
The price-to-earnings ratio or ‘per’ compares a company’s share price (P) to its most recent full-year earnings per share (E). Remember, ‘income’ is just another word for profit. Therefore, the ‘P/E’ ratio simply compares the share price to the company’s most recent full-year earnings. Some experts will try to tell you that ‘lower PE ratio is better’ because it means that the share price is ‘lower’ compared to the profit generated by the company. However, sometimes the share price is amazing for some reason!
Secondly, some very successful companies have been around for many years (a decade or more) and have never reported accounting profits – so the PE ratio cannot be used to value them.
So, we think it’s worth digging deeper than looking at the PE ratio and thinking to yourself ‘if it’s below 10x, I’ll buy it’.
One of the fundamental ratio models analysts use to value a bank share is to compare the PE ratio of the bank/share you are looking at with its peer group or competitors and try to determine whether the share price is overvalued, or undervalued. From there, and using the principle of mean reversion, we can multiply the earnings/earnings per share by the sector average (EX sector PE) to reflect what the average company would be worth. It’s like saying, ‘If all other stocks are worth ‘X’, this one should be too’.
If we take WBC’s share price today ($37.65), along with its FY24 earnings per share figure ($1.92), we can calculate the company’s PE ratio to be 19.6x. This compares with the banking sector average PE of 18x.
Next, take the earnings per share (EPS) ($1.92) and multiply it by the average PE ratio of WBC’s sector (Banking). This results in a ‘sector adjusted’ PE valuation of $34.71.
WBC Share Price: Price to Dividend
The dividend discount model or a ratio price like DDMPE is different because the model predicts into the future, and uses dividends rather than earnings. Since the banking sector has proved to be relatively stable in terms of profit sharing, the DDM approach can be used. However, we would not use this model for technology stocks that are more growth oriented.
Basically, we only need one input to the DDM model: earnings per share. Next, we make some assumptions about the risk level of annual dividend growth (eg 2%) and dividend payout (eg 7%). We have used the most recent full year’s profit (ie from last 12 months or LTM). Profits are assumed to remain constant but increase slightly.
To evaluate, use this formula: Share Price = Full Year Profit / (Risk Rate – Profit Growth Rate). It’s a good idea to do calculations using a few different growth and risk assumptions, then average the valuation. This helps to account for some of the uncertainty.
To simplify this DDM, we will assume that the previous year’s dividend payment (66 1.66) grows at a constant rate each year.
Next, we determine the ‘risk’ rate or expected rate of return. This is the rate at which we return future dividend payments in today’s dollars. A higher ‘risk’ rate results in a lower share price value.
We have used compounding rates for profit growth and risk rates between 6% and 11%, then averaged the results.
From this point of view, the share price of WBC. 35.10 is found. However, using an ‘adjusted’ dividend payout of 61 1.61 per share, the price goes to .034.05. Westpac Banking Corporation share price. 37.65 compared to
Since the company’s profits have been fully accounted for, you can make another adjustment and assess based on the ‘gross’ profit paid. ie cash dividends plus franking credit (available to eligible shareholders). Using the forecast gross dividend payout of ($2.30), our estimate of WBC’s share price comes to .648.64.
| Growth rate | ||||
| 2.00% | 3.00% | 4.00% | ||
|
Hazard ratio |
6.00% | . 40.25 | . 53.67 | . 80.50 |
| 7.00% | . 32.20 | . 40.25 | . 53.67 | |
| 8.00% | . 26.83 | . 32.20 | . 40.25 | |
| 9.00% | .00 23.00 | . 26.83 | . 32.20 | |
| 10.00% | .1 20.13 | .00 23.00 | . 26.83 | |
| 11.00% | . 17.89 | .1 20.13 | .00 23.00 | |
Key Summary
Simple valuation models like these can be handy tools to analyze and value a bank share like Westpac Banking Corporation. These models can make you feel all warm and fuzzy inside because you’ve put ‘worth it’.
That said, it’s far from a perfect diagnosis (as you can see). While no one can ever guarantee a return, there are things you can (and probably will) do to improve the valuation before you consider it a worthwhile yardstick.
For example, studying the growth or increase of total debts on the balance sheet is a very important task: if they are growing too fast, it means that the bank can take too much risk. Too slow and the bank may be too conservative. Next, study the rest of the financial statements for risks.
Areas of focus include provisions for bad debts (income statement), their rules for assessing bad debts (accounting notes) and sources of capital (wholesale debt markets or customer deposits). On the latter, note how much it costs the bank to get capital into its business to lend to consumers, bearing in mind that overseas debt markets are generally riskier than consumer deposits due to exchange rates, regulation and the fluid nature of investment markets.
