How much are National Australia Bank Ltd shares REALLY worth?

Over the past decade shareholders of National Australia Bank Ltd (ASX: NAB) have watched on helplessly as the value of their shares continued to underperform the bank's peers.

NAB's share price has substantially lagged Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ).

In fact, shareholders should be grateful it's paid a rising stream of dividends. Otherwise, those who bought NAB shares 10 years ago would be sitting on capital gains of just 6%.

A new horizon for NAB

Despite its underperformance relative to peers, NAB has continued to power ahead with asset growth in the Australian and New Zealand markets.

Moreover, its troubled assets in the USA and UK, which have long distracted its countless executive management teams, will likely be entirely removed from the bank's balance sheet in coming years, following recent decisions to sell the assets to public markets.

This will enable the group to focus on the more lucrative "core" markets of Australia and New Zealand.

However, it's worth noting that the UK banking assets account for just 5.7% of group profit, so investors must realise the divestment won't be NAB's saving grace. At least not overnight.

Indeed, its future outperformance will be heavily dependent on its performance in core markets.

In the Australian market throughout 2014 NAB achieved a return on assets (ROA) of just 0.7%. By comparison Westpac Group's ROA is around 0.9%.

That may not sound like much difference, but when you have $830 billion of assets, which NAB does, a tiny change in ROA can have a profound impact on profit.

For example, if NAB had the same ROA as Westpac I estimate its profit from the 2014 financial year would've been 40% higher.

NAB's recent anticipatory decision to respond to potential changes in regulations — requiring major local banks to hold billions of dollars of capital in reserve (in case of a market crash) — needs to be considered in the valuation of its shares.

This capital, known as Common Equity Tier One, or CET1, is a requirement set down by APRA — the banking regulator — and has the effect of reducing a bank's conventional profits margins, such as Return on Equity (ROE).

But investors cannot lay the blame entirely on regulation for NAB's falling profit margins. Intense competition, lack of acquisitive opportunities and mortgage brokers, have each played their part in eroding local banks' profit margins.

Indeed, recent comments from each of the big bank chiefs appear to be alluding to a couple of very important points:

1. Credit growth will be slower in the future, and
2. Intense competition will remain

Given that many analysts frequently assume the total asset growth of a 'good' bank will remain slightly ahead of GDP, it wouldn't be much of a stretch to assume NAB's credit growth will slow in coming years, in line with the broader economy.

3 ways to value NAB

Some investors will use NAB's price-earnings ratio, or P/E, as a barometer of value. It is a relative measure of value.

The P/E is an overused and oversimplified model of value. Further, there are added concerns using it to assess a bank's value because its profits are cyclical.

Nevertheless, an investor using the P/E ratio to put a fair price on NAB shares could reasonably infer a value of around $28.12, based on the current market prices of its key peers.

A more prudent way to put a relative value on NAB shares would be to use its book value, or its price to net asset value (PNAV) instead of earnings per share. This essentially gives its shares a value based on the size of its balance sheet, minus intangible items such as brands and goodwill.

Using this model, some investors may believe NAB's tangible assets deserve a price equivalent to around $39.52 per share. However, this valuation tool has significant shortcomings and should be used sparingly.

For example, as we noted above, NAB's assets are not nearly as profitable as its peers. So to assume its valuation will return to the average of its peers relative to assets probably isn't a fair and reasonable assumption.

Arguably, the most theoretically robust way to value NAB's shares is by using a dividend discount model, or DDM.

Forecasting future profit growth — calculated from the bank's ROA and asset (loan book) growth — and dividends is a great way to appreciate the future profitability of the bank.

However, the model must also incorporate constraints such as regulatory capital requirements and use a risk-adjusted discount rate.

Based on my forecasts of 3% annual asset growth (which is below the 6.5% achieved since the GFC), a ROA of 0.75% and a discount rate of 11%, I estimate the value of NAB shares lies somewhere around $25.07.

However, it's vital to remember that these types of models are far too simplistic to be relied upon in isolation. Moreover, I'm a firm believer no one can truly know the exact worth of any company's shares, let alone one as complicated as NAB.

By using a somewhat arbitrarily weighted valuation (based on theoretical robustness) of all of our three models, we arrive at a fair value estimate of $28.27 for NAB shares.

As always, we must demand a margin of safety between what we think a stock is worth, and what we can buy it for.

Personally, I try to buy shares for 30% less than their theoretical, or intrinsic value. So, in this case, I'd aim to buy NAB shares for less than $20.

Currently priced at $32.82, I don't know if I'll be able to buy NAB shares anytime soon.

But until that time comes, I'll be waiting patiently…

…or buying other great stocks!