What are NAB shares potentially worth in September?
Get a stadium share price analyst’s target price for an ASX bank share like National Australia Bank Ltd (ASX: NAB) is never a certainty. However, a thorough assessment can help you understand what’s going on under the hood.
Major Australian banks account for around 20% of the equity market as 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 went through a recession and mortgage interest rates were above 15%!
One of the great advantages of banks is that, for the most part, they are âimplicitlyâ protected against a complete financial collapse or bankruptcy, as a bank shutting down would be a political nightmare. In saying this, as we have seen recently, returns to shareholders are never guaranteed.
Valuation of the price-earnings sector
The price-to-earnings ratio or “PER” compares a company’s stock price (P) to its earnings per share (E) for the most recent year. Remember that “earnings” is just another word for profit. Therefore, the âP / Eâ ratio simply compares the stock price to the company’s most recent annual earnings. Some experts will try to tell you that âlower PE ratio is betterâ because it means that the stock price is âlowâ relative to the profits generated by the company. However, stocks sometimes have good value for a reason!
Second, there are some extremely successful businesses that have been around for many years (a decade or more) and have never reported accounting profit – so the PE ratio would not have worked.
Therefore, we think it makes sense to dig deeper than just looking at the PE ratio and thinking to yourself âif it’s less than 10x, I’ll buy itâ.
One of the simple ratio models that analysts use to value a bank stock is to compare the PE ratio of the bank to the stock you’re looking at with its peer group or competitors and try to determine if the stock is. too high or underestimated compared to the average. From there, and using the principle of reversion to the average, we can multiply the earnings / earnings per share by the sector average (Ex sector PE) to reflect what an average company would be worth. It’s like saying “if all the other stocks are listed at ‘X’, this one should be too.”
If we take NAB’s stock price today ($ 27.89), along with its fiscal 2020 earnings (or earnings) per share data ($ 0.805), we can calculate the PE ratio of the company at 34.6x. This compares to the average banking sector PE of 24x.
Then take the earnings per share (EPS) ($ 0.805) and multiply it by the average PE ratio of the NAB (Banking) industry. This translates to an âsector adjustedâ PE valuation of $ 19.70.
Dividend Models (a 101 walkthrough)
The dividend discount model or DDM is different from ratio valuation like the PE because the model predicts the future and uses dividends instead of profits. Since the banking sector has been shown to be relatively stable with regard to stock dividends, the DDM approach can be used. However, we wouldn’t use this model for, say, tech stocks.
Basically, we only need one entry in a DDM model: dividends per share. Next, we make some assumptions about the annual dividend improvement (eg 2%) and the risk level of the dividend payment (eg 7%). We used the most recent full year dividends (e.g. last 12 months or LTM) then assumed dividends remain constant but increase slightly.
To make this DDM easy to understand, we’ll 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 âriskâ rate or the expected rate of return. This is the rate at which we discount future dividend payments in today’s dollars. The higher the âriskâ rate, the lower the valuation of the share price.
We used an average rate for dividend growth and a risk rate of between 6% and 11%.
This simple DDM valuation of NAB shares is $ 11.44. However, using an âadjustedâ dividend payment of $ 1.12 per share, the valuation rises to $ 20.08. The expected dividend valuation compares to the National Australia Bank Ltd share price of $ 27.89. Since the company’s dividends are fully franked, you can choose to make an additional adjustment and valuation on the basis of a âgrossâ dividend payment. That is, cash dividends plus postage credits (available to eligible shareholders). Using the expected gross dividend payout ($ 1.60), our valuation of the NAB stock price is expected at $ 28.68.
It’s time to continue the research
It goes without saying that these two valuation strategies are only the starting point of the process of analysis and valuation of a bank share like NAB. If we were to look at stocks and consider an investment, we would like to know more about the bank’s growth strategy. Do net interest margins hold up if they seek more loans (i.e. interest income)? How do they deal with regulation if they are looking for more income other than interest (fees for financial advice, investment management, etc.)?
Finally, it is always important to do an assessment of the leadership team. For example, when we pulled crop data from National Australia Bank Ltd, we found it wasn’t a perfect 5/5. No company has a perfect culture, of course. However, culture is something we think about a lot when we analyze companies to buy and hold for the very long term (10 years and more).