ANZ share price nears $26: 2 steps to assess stocks
Arriving at intrinsic valuation is one of the most popular questions or topics our senior investment analysts receive from Australian investors, particularly those seeking dividend income. It’s not exclusive to the ANZ banking group, of course.
National Australia Bank Ltd (ASX:NAB) and Commonwealth Bank of Australia (ASX: CBA) 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 franking credits.
How to use PE ratios
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 ($25.83). Unfortunately, it’s not the perfect tool for bank stocks, so it’s important to use more than PE ratios 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 ANZ’s stock price today ($25.83), 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 21.3x. This compares to the banking industry average PE of 23x.
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 $27.73.
A simple guide to valuing ANZ using dividends
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 ($0.60) 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 $25.83. 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.
Where to go 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 ANZ Banking Group shares and considering an investment, take the 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 important to take stock of the management team.