WBC Stock Price Nears $21: 2 Techniques to Value Stocks
Getting an analyst valuation is one of the most popular questions or topics our senior investment analysts receive from Australian investors, especially those seeking dividend income. It’s not exclusive to Westpac Banking Corp, of course.
Bank of Queensland Limited (ASX:BOQ) and National Australia Bank Ltd (ASX:NAB) are also very popular stocks on the ASX.
Before we go through two valuation models you could use to answer the question yourself, let’s take a look at why investors love bank stocks in the first place.
Alongside the technology and industrials sectors, the financial/banking sector is one of the favorites of Australian investors. The largest banks, including Commonwealth Bank of Australia and National Bank of Australia operate in an “oligopoly”.
And while major international banks, such as HSBC, have attempted to encroach on our ‘Big Four’, the success of foreign competitors has been very limited. In Australia, ASX bank stocks are particularly popular with dividend investors looking for postage credits.
Make a ‘Comps’ assessment
The price-to-earnings ratio, which is short for price-to-earnings, is a basic but popular valuation ratio. It compares the annual profit (or “earnings”) to the current share price ($21.12). Unfortunately, it’s not the perfect tool for bank stocks, so using more than just PE ratios is essential for your analysis.
That said, it can be useful to compare PE ratios between stocks in the same sector (banking) and determine what is reasonable and what is not.
If we take WBC’s stock price today ($21.12), along with earnings (i.e., earnings) per share data for its fiscal year 2020 ($0.637), we we can calculate the company’s PE ratio at 33.2x. This compares to the banking sector average PE of 21x.
Next, take earnings per share (EPS) ($0.637) and multiply it by the average PE ratio for the WBC (Banking) sector. This translates to a “sector-adjusted” PE valuation of $13.54.
What are dividends really worth?
A DDM is a more attractive and robust way of valuing companies in the banking sector, given that the dividends are fairly constant.
DDM valuation modeling is one of the oldest methods used on Wall Street to value companies, and it is still used here in Australia by banking analysts. A DDM model takes the most recent full year dividends (e.g. last 12 months or LTM), or expected dividends, for the next year, then assumes dividends grow at a constant rate over a forecast period (e.g. 5 years or forever).
To make this DDM easier to understand, we will assume that last year’s dividend payment ($0.89) 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 WBC stock is $16.97. However, using an “adjusted” dividend payment of $1.25 per share, the valuation jumps to $22.41. The expected dividend valuation compares to Westpac Banking Corp’s share price of $21.12. 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 ($1.79), our valuation of WBC stock price is estimated at $32.01.
Key takeaways – what to do from here
Please keep in mind that these valuation methods are just the starting point of the research and evaluation process. Please remember this. Banks are very complex businesses and if the 2008/2009 GFC taught investors anything, it was that even the “best” banks can fail and drag shareholders down with them.
If you’re looking at Westpac Banking Corp stock and considering an investment, take your time to learn more about the bank’s growth strategy. For example, is it looking for more loans (i.e. interest income) or more non-interest income (financial advice fees, investment management, etc.)? Next, take a close look at economic indicators such as unemployment, house prices and consumer sentiment. Finally, it is always essential to take stock of the management team.