Right now, you can probably use Google or another data provider to see the the price of National Australia Bank Ltd (ASX: NAB) is around $ 28 per share. But what are NAB stocks really worth?
Achieving an analyst course target is one of the most popular questions or topics our senior investment analysts ask Australian investors, especially those seeking dividend income. This is not exclusive to National Australia Bank Ltd, of course.
Westpac banking company (ASX: WBC) and ANZ Banking Group (ASX: ANZ) are also very popular stocks on the ASX.
Before we go over two valuation models that you could use to answer the question yourself, let’s see why investors love bank stocks in the first place.
Alongside the tech and industrial sectors, the financial / banking sector is one of the favorites for Australian investors. The largest banks, including Commonwealth of Australia Bank and National Bank of Australia operate in an “oligopoly”.
And while large international banks, such as HSBC, have tried to encroach on our “Big Four”, the success of foreign competitors has been very limited. In Australia, ASX bank stocks are particularly preferred by dividend investors seeking postage credits.
Invert the PE ratio for valuations
The price-to-earnings ratio or “PER” compares a company’s share price (P) to its most recent annual earnings per share (E). Remember that “earnings” is just another word for profit. Therefore, the “P / E” ratio simply compares the stock price to the company’s most recent annual earnings. Some experts will try to tell you that “lower PE ratio is better” because it means that the stock price is “low” 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 “if it’s less than 10x, I’ll buy it”.
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 mean reversion principle, we can multiply the earnings / earnings per share by the industry average (E x PE of the industry) 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 ($ 28.2), along with its fiscal 2020 earnings (or earnings) per share data ($ 0.805), we can calculate the PE ratio of l company at 35x. This compares to the average banking sector PE of 24x.
Next, 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 “sector adjusted” PE valuation of $ 19.15.
The first valuation tool for the brokerage firm: the dividend model
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 “risk” 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 “risk” rate, the lower the valuation of the share price.
We have 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 “adjusted” dividend payment of $ 1.23 per share, the valuation rises to $ 22.05. The expected dividend valuation compares to the National Australia Bank Ltd share price of $ 28.20. Since the company’s dividends are fully franked, you can choose to make an additional adjustment and valuation on the basis of a “gross” dividend payment. That is, cash dividends plus postage credits (available to eligible shareholders). Using the expected gross dividend payout ($ 1.76), our valuation of the NAB stock price predicts $ 31.50.
Please note 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 is that even the “best” banks can close their doors and drag shareholders with them.
If you are researching National Australia Bank Ltd stocks and considering an investment, take the time to learn more about the bank’s growth strategy. For example, is she looking for more loans (i.e. interest income) or more non-interest income (fees for financial advice, investment management, etc.)? Then take a close look at economic indicators such as unemployment, house prices, and consumer confidence. Finally, it is always crucial to take stock of the management team.