Our top banking stocks represent more than a third of the local stock market, measured by the market capitalization of the 200 largest companies in the S&P/ASX 200 Index.
If you really want to understand how to value a dividend stock, such as a bank or REIT, you should consider looking at the video tutorial from Rask Australia’s analyst team.
Inside the PE Assessment
If you’ve been investing in individual stocks or companies for more than a few years, you’ll have heard of the PE ratio. The price-to-earnings ratio or “PER” compares a company’s stock price (P) to its latest earnings per share (E) for the entire year. If you bought a cafe for $100,000 and it made $10,000 in profit last year, that’s a price-to-earnings ratio of 10x ($100,000/$10,000). “Profit” is just another word for profit. Thus, the PE ratio essentially indicates “annual price/earnings multiple”.
The PE ratio is a very simple tool but it is not perfect so it should only be used with other techniques (see below) to back it up. That said, one of the basic ratio strategies that even professional analysts will use to value a stock is to compare the company’s PE ratio with its competitors to try to determine if the stock is unreasonably high or cheap. This is the same as saying: “if all the other stocks in the banking sector are quoted at a PE of X, this one should be too”. We will go further than that in this article. We will apply the principle of mean reversion and multiply earnings per share (E) by the industry average PE ratio (E x industry PE) to calculate the value of an average company.
If we take BOQ’s stock price today ($6.91), along with earnings (i.e., earnings) per share data for its fiscal year 2020 ($0.511), we we can calculate the company’s PE ratio at 13.5x. This compares to the banking sector average PE of 21x.
Next, take earnings per share (EPS) ($0.511) and multiply it by the average PE ratio for the BOQ (Banking) industry. This translates to a “sector-adjusted” PE valuation of $10.98.
Dividend patterns – a return to Wall St
A DDM or dividend discount model is quite different from ratio valuations like PER because it allows you to forecast cash flows in the future (it uses dividends as “cash flow”). 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 growth of the dividend (eg 2%) and the level of risk 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 ($0.12) climbs 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 BOQ stock is $2.29. However, using an “adjusted” dividend payment of $0.39 per share, the valuation jumps to $6.99. The expected dividend valuation compares to Bank of Queensland Limited’s share price of $6.91. 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 ($0.56), our assessment of the BOQ stock price projection at $9.99.
What to do now
Our two templates could serve as an introductory guide to how the assessment process works. Analyzing a bank stock like Bank of Queensland Limited is a complicated task. If we were looking at stocks and considering an investment, we would first want to know more about the bank’s growth strategy. For example, are they 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. Where are they going ? Finally, we believe it is important to assess the management team. For example, when we extracted culture data from BOQ, we found that it was not a perfect 5/5. Culture is something to think about.