NAB stock price is approaching $32, here are 2 approaches to valuing it
Reaching an analyst price target is one of the most popular questions or topics that our senior investment analysts receive from Australian investors, especially those seeking dividend income. It’s not exclusive to National Australia Bank Ltd, of course.
Westpac Banking Corp. (ASX:WBC) and ANZ Banking Group (ASX: ANZ) 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.
Invert the PE ratio for valuations
The price/earnings ratio or “PER” compares a company’s stock price (P) to its latest earnings per share (E) for the full year. Remember that “benefits” 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 the stock price is “low” relative to the earnings generated by the company. However, stocks are sometimes good value for a reason!
Second, some extremely successful companies have operated for many years (a decade or more) and never reported a book profit – so the PE ratio wouldn’t have worked.
Therefore, we think it makes sense to dig deeper than just looking at the PE ratio and thinking “if it’s below 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 are looking at with its peer group or competitors and try to determine if the stock is too high or undervalued compared to the average. From there, and using the principle of mean reversion, we can multiply earnings/earnings per share by the industry average (E x sector PE) to reflect what an average company would be worth. It’s like saying, “If every other stock has the price of ‘X’, so should this one.”
If we take NAB’s stock price today ($32.35), 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 40.2x. 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 $20.15.
The stockbroker’s first valuation tool: the dividend model
The Dividend Discount Model or DDM is different from the valuation of ratios like the PE because the model forecasts into the future and uses dividends instead of profit. Since the banking sector has proven to be relatively stable with respect 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 input in a DDM model: dividends per share. Next, we make 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 assume dividends remain constant but increase slightly.
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 $32.35. 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 forecast at $31.50.
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 National Australia Bank Ltd 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 (fees for financial advice, investment management, etc.)? Next, take a close look at economic indicators such as unemployment, house prices and consumer sentiment. Finally, it is always crucial to take stock of the management team.