Are Westpac Banking Corp shares ridiculously cheap?

Credit: perry carbonell

Westpac Banking Corp (ASX: WBC) shareholders haven’t had the greatest year, so far. In fact, Westpac shares have underperformed the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) by 11% this year.

Source: Google Finance

Source: Google Finance

And with shares underperforming the market, no doubt, some investors will be wondering if Westpac shares are ridiculously cheap?

How we can value Westpac

Firstly, it is always important to remind ourselves that blue-chip shares like Westpac will rarely fall into ‘bargain territory’. Indeed, for any blue chip company, let alone one with a market capitalisation of $102 billion, there is usually a swarm of analysts documenting the company’s every move day-in-day-out.

That means it’s usually only during times of severe market dislocation that shares of companies like Westpac will trade significantly below their fair value.

Nonetheless, not every investor has capital growth as a priority. Therefore, it can be useful to value some companies on the basis of the income they produce.

With a forecast payment of $1.88, Westpac shares yield a dividend equivalent to 6.2% at today’s prices. Together with its franking credits, the comparable dividend yield blows out to an impressive 8.8% — try getting that from a term deposit!

However, according to traditional investment theory, we must discount those dividends by a required rate of return, and adjust for any growth. It’s a relatively simple process.

Westpac’s return on equity (ROE) gives us part of the growth equation (perhaps you can  now see why banks always trumpet their ROE in media presentations!) and I’ll choose a somewhat arbitrary required rate of return of 10% — similar to the expected return of the share market over the ultra-long-term.

Plugging those numbers into my dividend discount model (DDM) renders a value of $28.77.

Cheap or not?

Bearing in mind this is a very simple (though frequently used) measure of value, Westpac’s current market price of $30.37 is above the model’s estimated worth at $28.77. A slight overvaluation doesn’t make it a sell, but perhaps adds to the case that it isn’t a bargain at today’s levels.

Foolish takeaway

With increasing regulation and competition in the domestic banking sector, I would not be a buyer of any bank shares, including Westpac, unless they were meaningfully undervalued. Moreover, though its dividend yield is very tempting in a low-interest rate environment, I’m looking for other dividend stock ideas to add to my portfolio.

Like the one The Motley Fool's expert analysts hand-picked as their best dividend share idea for 2016.

Our resident dividend experts named this Top Dividend Share for 2016 because not only are the shares dirt cheap, the company is growing and trading on a BIG fully franked dividend yield. Simply click here to gain access to this comprehensive FREE investment report, including the name of this fast growing ASX dividend share. No credit card required!

Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned in this article. Owen welcomes -- and encourages -- your feedback on Google+, LinkedIn or you can follow him on Twitter @ASXinvest.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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