Up 13% this year, is NAB’s share price too much?
No one can tell you for sure if now is the perfect time to buy.
In the short term, the stock market can seem like a random place. It may be up 2% one day, down 3% the next. There’s often no rhyme or reason (though pundits get paid dearly for the evening news to trick you into thinking they have a crystal ball).
In this article, we’ll go step-by-step through two simple valuation tools that you can use to evaluate a stock like NAB or even Westpac Banking Corp. (ASX:WBC) and ANZ Banking Group (ASX: ANZ).
Valuation of the price-earnings sector
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 crucial to use it with other techniques (see below) to back it up. That said, one of the ballpark ratio strategies that even professional analysts will use to value a stock is to compare the company’s PE ratio with its competitors to try to determine if the stock is too high 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 the value of an average company.
If we take NAB’s stock price today ($33.14), along with earnings (i.e., earnings) per share data for its fiscal year 2020 ($0.805), we we can calculate the company’s PE ratio at 41.2x. This compares to the banking industry average PE of 25x.
Next, take earnings per share (EPS) ($0.805) and multiply it by the average PE ratio for NAB’s (Banking) sector. This translates to a “sector-adjusted” PE valuation of $20.24.
Dividend Patterns (a 101 walkthrough)
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 constant rate in the future at a fixed annual rate.
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 an average dividend growth rate and a risk rate between 6% and 11%.
This simple DDM valuation of NAB stock is $11.44. However, using an “adjusted” dividend payment of $1.23 per share, the valuation jumps to $22.05. The expected dividend valuation compares to National Australia Bank Ltd’s share price of $33.14. 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 ($1.76), our valuation of NAB’s stock price is estimated at $31.50.
It’s time to continue the search
Remember that the two models used here are only the starting point for the process of analyzing and valuing a bank stock like NAB.
We believe it is good practice to read at least three years of annual reports, write down your thoughts/research, and lay out your thesis/expectations based on what management is saying. Indeed, a very useful tool is the study of management language in presentations and videos. Is the management team honest? Or does he/she use a lot of jargon and never answer a direct question? Finally, read articles and research from good analysts, and when you do, look for people who disagree with you. These voices are often the most useful.
These are just a few of the best strategies to use with your assessment tools to determine if you are making a mistake – hopefully, before you make a costly mistake!