How much are Westpac Banking Corp shares really worth?

Pop quiz: Does Westpac Banking Corp (ASX: WBC) hedge interest rate risk and foreign exchange risk from debt issuances using single currency and cross-currency rate derivatives?

If you were lucky enough to answer, "Yes", well done…

…luck part plays a big part in many investment decisions.

However, the undeniable truth is many Australian investors have done well from bank stocks likely without ever looking at their balance sheets or having a full understanding of their financials.

I can't blame you… they're not exactly light reading!

And even if you regularly stare at balance sheets, I strongly doubt anyone could honestly say they know exactly what Westpac shares are worth.

Westpac's last annual report was 308 pages long!

Don't trust the P/E ratio!

To overcome the perplexing nature of bank reports and make the sell to clients easier, the stock-picking community has developed a number of simple valuation tools.

These tools have come about by picking and choosing particular line items from bank statements to place a value upon shares.

The most common valuation ratio is the price-earnings ratio, or P/E.

It takes the current market price for shares and divides it by the proportionate profits, or earnings per share. The P/E is a relative valuation measure because by itself it doesn't really tell you anything useful.

It must be related to the P/E of another – preferably similar – company to be insightful.

Westpac's P/E is 12.7x. The market, or S&P/ASX 200 (ASX: XJO) (Index: ^AXJO), currently has an average P/E of 16.6x.

Some commentators will suggest that due to Westpac's P/E being lower than the markets, it will return to some sort of average, or 'mean', level. That's complete tripe.

The P/E is not indicative in any way of the underlying business and whether it returns to the mean or not is complete speculation.

It is a static measure which conveys market prices – which are volatile and change every day – to earnings, which either come from last year or are based on projected data. The latter can also be wrong.

If Westpac's P/E did return to the mean of the market however its fair value would be $40.76. Its highest ever share price, achieved in early 2015, was $40.07.

It's important to note here, Westpac's profits are cyclical. Just think about how a credit crunch would hurt its ability to post record profits.

For example, few people would be taking out mortgages. More would be defaulting on loans.

Sure, over the past 10 years Westpac's loan book has more than tripled. However, in the time we've had a housing boom, record household debt levels, and not one recession. Moreover, Westpac also acquired St.George, which boosted the loan portfolio.

Unfortunately, given the competitive concerns and regulatory landscape, major acquisitive growth opportunities are likely off the table for the foreseeable future.

During an economic downturn, Westpac's provisions for bad and doubtful debts will skyrocket (they're currently at a cyclical low) and this will be deducted directly from profits.

Leverage to the market cycle means the P/E ratio is even less meaningful for the valuation of bank stocks as opposed to say Telstra Corporation Ltd (ASX: TLS), which has more reliable earnings over the market cycle.

A more reliable way to value bank shares is to use the price-book or Price to Net Tangible Assets (PNAV) ratio.

The PNAV relates market price to the physical (tangible) assets on a bank's balance sheet. It excludes things like goodwill, capitalised software and brand names.

By way of example, Westpac's current PNAV of approximately 2.64x means investors are paying more than two-and-a-half times the worth of its physical assets, as judged by the accountants, to own its stock.

Using the average PNAV of some of Westpac's peers, it's easy to see investors place a value on its assets which is roughly in the middle of the pack. This can be expected because Westpac's profitability is also roughly in the middle of the pack.

However, if we assume a return to the mean, Westpac's fair/intrinsic value would be around $27.02.

Obviously, there's a big difference between our intrinsic PNAV and the P/E value above.

Personally I'd say the intrinsic PNAV has more merit than the P/E ratio because banks make money from their assets (loans) so it's more indicative of the fundamental underlying value of the operations.

The Dividend Discount Model

Usually, analysts will incorporate a discounted cash flow analysis (DCF) into their valuations when they complete a research report. As noted above however banks are not easy to value.

Instead, analysts can use a dividend discount model.

A dividend discount model, or DDM, takes the future value of dividends and discounts them back to present dollars using the cost of equity as the discount rate. However, we must be mindful to include capital adequacy into our model.

Currently, APRA requires the biggest banks to hold around 8% common equity in reserve in order to buffer against a potential market crash or economic downturn. The bank must hold the required capital before it can pay dividends.

That's why there's always so many doomsayers in the financial press harking on about banks not being able to pay dividends. Sure, higher capital requirements are a concern. But personally I doubt the banks will cut their dividends entirely to boost capital buffers.

For example, Westpac recently issued $2 billion worth of shares through its dividend reinvestment plan to boost its capital position.

Based on my simplified dividend discount model, incorporating average growth in total assets of 3.5% over the next five years and a return on assets of around 0.9%, Westpac's shares are currently worth around $25.81.

That is, 20% less than they trade for today.

It's worth noting, Westpac's total assets have grown at 6% over the past four years. In addition, throughout financial year 2014, its return on assets was 0.98% whereas based on its current run rate, its return on assets is 0.906%.

Now, you might be asking why I was so conservative on my total asset growth figure.

I lowered the total asset growth rate significantly (from 6% to 3.5%) because all of the big banks' CEOs have forecast intense competition moving forward. Plus, we're at the top of the market cycle so I'd rather be conservative.

What are Westpac shares really worth?

Under a somewhat arbitrarily weighted valuation model using our P/E, PNAV and DDM figures, I believe fair value for Westpac lies somewhere around $27.67.

Are there risks in your model?

However, to adjust for the huge amount of uncertainty in each of our valuation models we must aim to purchase shares for significantly LESS than fair value.

Indeed, to adjust for the likelihood of being wrong on valuation, investors should always demand a margin of safety between what they think a stock is worth (i.e. intrinsic/fair value) and what they can buy it for (i.e. the market price).

I aim to buy shares at no less than a 30% discount to what I think they are worth.

In this instance, Westpac shares would need to trade below $20.00 before I'd buy.

Until then, I'm waiting patiently…

…or buying other great stocks!