Australia’s major banks make up about 30% of the share market, measured by market capitalization (total company size).
It’s easy to see why ASX bank shares have been so popular since the early 1990s, when Australia faced recession and mortgage interest rates were over 15%!
One of the great things about banks is that, for the most part, they are completely immune to financial collapse or bankruptcy because a bank going out of business would be a political nightmare. Having said that, as we have seen recently, shareholder returns are never guaranteed.
Using the PE ratio for valuation
If you’ve been investing in individual stocks or companies for a few years, you’ve probably heard of 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 in profit last year, that’s a price-earnings ratio of 10x ($100,000 / $10,000). ‘Earnings’ is just another word for profit. So, PE ratio is basically saying ‘price to annual profit multiple’.
The PE ratio is a very handy tool but it is not perfect and should only be used in conjunction with other techniques (see below) for backup. That said, one of the basic ratio strategies that even professional analysts will use to value a stock is to compare a company’s PE ratio with that of its competitors to try to determine whether the stock is unreasonably overvalued, or undervalued. This is equivalent to saying: ‘If all other stocks in the banking sector are priced at a PE of X, then so should it’. We will go one step further in this article. We will apply the principle of average change and multiply the earnings per share (E) by the sector average PE ratio (E x sector PE) to estimate what an average company would be worth.
If we take today’s BOQ share price ($6.24) along with the earnings (ie profit) per share data from its FY24 fiscal year ($0.41), we can calculate the company’s PE ratio at 15.2x. This compares to the banking sector average PE of 18x.
Next, take the earnings per share (EPS) ($0.41) and multiply it by BOQ’s sector (banking) average PE ratio. This results in a ‘sector adjusted’ PE valuation of $7.22.
BOQ Share Price: Dividend Valuation
The DDM or Dividend Discount Model differs substantially from evaluating ratios like PER because it requires forecasting cash flows – using dividends as a proxy for cash flows – into the future. The DDM approach works well for the banking sector, which has a relatively stable dividend payout history. However, it is less suitable for industries such as technology, where companies are more focused on growth than paying consistent dividends.
The key input for the DDM is the dividend per share. From there, we make assumptions about the annual dividend growth rate (eg 2%) and the associated risk level, or required return (eg 7%). For this analysis, we used the most recent full-year returns (eg trailing 12 months or LTM) and Assume that profits remain constant but increase marginally over time..
The evaluation formula is straight forward: Share price = Full year dividend / (Rate of risk – Rate of return). It is advisable to perform calculations with a range of growth and hazard rate assumptions, then average the results. This way you can account for more uncertainty and arrive at a more balanced assessment estimate.
To simplify this DDM, we will assume that last year’s dividend payment ($0.34) 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 discount future dividend payments in today’s dollars. A higher ‘risk’ rate results in an undervaluation of the share price.
We’ve used a blended rate of return and a risk rate between 6% and 11%, then averaged the results.
This approach yields a BOQ share price of $7.19. However, using an ‘adjusted’ dividend payout of $0.35 per share, the valuation jumps to $7.40. The expected dividend value compares to Bank of Queensland Limited’s share price of $6.24.
Since the company’s dividend is fully transparent, you can make another adjustment and make a valuation based on the ‘gross’ dividend payout. ie cash dividends plus franking credits (available to eligible shareholders). Using the forecast gross dividend payout of ($0.50), our BOQ share price comes out to $10.57.
| Growth rate | ||||
| 2.00% | 3.00% | 4.00% | ||
|
Hazard ratio |
6.00% | $8.75 | $11.67 | $17.50 |
| 7.00% | $7.00 | $8.75 | $11.67 | |
| 8.00% | $5.83 | $7.00 | $8.75 | |
| 9.00% | $5.00 | $5.83 | $7.00 | |
| 10.00% | $4.38 | $5.00 | $5.83 | |
| 11.00% | $3.89 | $4.38 | $5.00 | |
Key Summary
It goes without saying that these two valuation strategies are just the beginning of the process of analyzing and valuing a bank share like BOQ. And if we were looking at bank shares like Bank of Queensland Limited, we’d certainly want to know whether it makes more sense to just invest in a low-cost, dividend-paying ETF. Vanguard Australian Shares Index ETF (ASX: VAS).
Other questions to ask might be: Is the net interest margin sustainable if they are pursuing more lending (ie interest income)? How are they dealing with regulation if they want more non-interest income (fees from financial advice, investment management, etc.)?
Finally, it is always important to assess the management team. For example, when we pulled data on Bank of Queensland Limited’s culture, we found it wasn’t a perfect 5/5. Of course, no company has a perfect culture. However, culture is something we think about a lot more when analyzing very long term (10+ years) companies to buy and hold.
