Big Australian banks make up around 20% of the equity market, measured by market capitalization and inclusion in the S&P/ASX 200 Index.
It’s easy to see why ASX bank stocks have been so popular since the early 1990s when Australia hit a recession and mortgage interest rates were over 15%!
A great thing about banks is that, for the most part, they are “implicitly” protected against complete financial collapse or bankruptcy, because a bank that failed would be a political nightmare. In saying that, as we have seen recently, shareholder returns are never guaranteed.
Get a price on profit (PE ratio)
Chances are, if you’ve been actively investing in stocks for more than a few years, you’ll have heard of the PE ratio. The price-to-earnings ratio or “PER” compares a company’s stock price (P) to its latest earnings per share (E) for the entire year. If you bought a cafe for $100,000 and it made $10,000 in profit last year, that’s a price-to-earnings ratio of 10x ($100,000/$10,000). “Profit” is just another word for profit. Thus, the PE ratio essentially indicates “annual price/earnings multiple”.
The PE ratio is a very general tool but it is not perfect, so it is important to use it with other techniques (see below) to back it up. That said, one of the standard ratio strategies that even professional analysts will use to evaluate a stock is to compare the company’s PE ratio with its competitors to try to determine if the stock is excessive or cheap. This is the same as saying: “if all the other stocks in the banking sector are quoted at a PE of X, this one should be too”. We will go further than that in this article. We will apply the principle of mean reversion and multiply earnings per share (E) by the industry average PE ratio (E x industry PE) to calculate what an average company would be worth.
If we take ANZ’s stock price today ($23.55), along with earnings (i.e., earnings) per share data for its fiscal year 2020 ($1.21) , we can calculate the PE ratio of the company at 19.5x. This compares to the banking industry average PE of 22x.
Next, take the earnings per share (EPS) ($1.21) and multiply it by the average PE ratio for the ANZ (Banking) sector. This translates to a “sector-adjusted” PE valuation of $26.51.
What are ANZ dividends worth?
A Dividend Discount Model or DDM is a much more robust way of valuing companies in the banking industry – if done correctly (take your time!).
DDM valuation models are among the oldest valuation models used on Wall Street and even here in Australia. A DDM model uses the most recent full year dividends (e.g. last 12 months or LTM) or expected dividends for the next year, then assumes dividends remain constant or increase slightly for the forecast period (e.g. 5 years or forever).
To make this DDM easier to understand, we will assume that last year’s dividend payment ($0.60) increases at a fixed rate each year.
Then we choose the “risk” rate or the expected rate of return. This is the rate at which we discount future dividend payments into today’s dollars. The higher the “risk” rate, the lower the stock price valuation.
We used a blended rate for dividend growth and a risk rate between 6% and 11%, then got the average.
This simple DDM valuation of ANZ shares is $11.44. However, using an “adjusted” dividend payment of $1.40 per share, the valuation jumps to $25.10. The expected dividend valuation compares to ANZ Banking Group’s share price of $23.55. Since the company’s dividends are fully franked, you may choose to make an additional adjustment and make the valuation on the basis of a “gross” dividend payment. That is, cash dividends plus franking credits (available to eligible shareholders). Using the expected gross dividend payment ($2.00), our valuation of the ANZ share price is estimated at $35.85.
It goes without saying that these two valuation strategies are only the starting point in the process of analyzing and valuing a bank stock like ANZ. If we were looking at stocks and considering an investment, we would want to know more about the bank’s growth strategy. Do net interest margins hold up if they pursue more loans (i.e. interest income)? How do they handle regulation if they are looking for more non-interest income (fees for financial advice, investment management, etc.)?
Finally, it is always important to take stock of the management team. For example, when we pulled data on culture from ANZ Banking Group, we found that it was not a perfect 5/5. No company has a perfect culture, of course. However, culture is something we think about a lot when analyzing companies to buy and keep for the very long term (10+ years).