With the WBC stock price at $24: Use these techniques to find it
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 franking credits.
Using comps for PE ratios
The “PE” ratio compares a company’s stock price (P) to its earnings per share (E) for the most recent full year. Remember that “benefits” is just another word for profit. This means that the PE 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 cheap 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’s essential 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 in the money ratio. on 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 WBC’s stock price today ($23.72), 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 37.2x. This compares to the banking industry average PE of 23x.
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 $14.70.
Why fully franked dividends drive up WBC stock price
Since ASX bank stocks like WBC tend to pay dividends – and they are relatively stable companies like REITs or ETFs – we can use a modeling tool called the Dividend Discount Model or DDM to make an assessment .
A DDM uses the dividends shareholders are expected to receive to arrive at a valuation.
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 $23.72. 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 estimate of the WBC stock price forecast at $32.01.
WBC stock price, key takeaways
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 (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 essential to take stock of the management team.