Question 3 – Share Valuation (38 marks)
Read the article below and answer the following questions. You may need to do some of your own additional research.
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Housing, banks at risk of significant overvaluation: ANALYST OPINION
by Christopher Joye
Two markets are at risk of significant overvaluation – Australia’s $4 trillion housing sector and the $405 billion big banks (Commonwealth Bank, NAB, Westpac and ANZ) that furnish most of the funding we use to buy homes.
Two of the majors, Commonwealth Bank of Australia and Westpac, are worth more than $100 billion each – more than global icons such as McDonald’s and American Express. Amazingly, CBA’s market capitalisation is loftier than the world’s largest chip manufacturer, Intel.
Since there is so much hysteria around housing, it is useful to focus on cold facts.
So here are some more facts. Today, Australian house prices are more expensive than they have ever been. They are 16 per cent above the peak reached in March 2008 before the global financial crisis hit our shores. Yet, prices are also more than 2 per cent dearer than the last official high watermark in October 2010….The bottom line is that we may be only six months away from Australia’s housing market being more expensive than it ever has been. That should give all of us pause.
With the risk that mortgage rates need to increase by 50 per cent off their lows of about 5 per cent to get back to the more “normal- levels that have prevailed since the early 1990s, the potential for a future correction is significant.
New normal
….The challenge for banks today is that credit growth is likely to remain anchored by singledigit disposable income growth over the course of the cycle. A key question is how the majors have manufactured strong earnings per share and dividend growth during these straitened times.
The answer is found in accounting and capital management manipulations.
Analysis by UBS shows 51 per cent and 69 per cent of the major banks’ earnings per share growth over the past six months and 12 months, respectively, was explained by non-cash reductions in provisions for bad and doubtful debts.
If you remove these effects, earnings per share growth fell 0.2 per cent in the second half of 2013. That’s right: bank profits declined! A similar story also plays out over the full financial year.
Lessons of GFC
A key lesson from the GFC was meant to be that banks would boost their insurance against losses during the good times so they could draw down on this protection when conditions sour.
…Looking ahead, big bank investors need to be mindful of two key headwinds.
The first is that as systematically important institutions that are “too big to fail-, the majors will be asked to hold even more core capital to protect against adverse future contingencies. This should mechanically result in lower leverage and returns on equity.
A second threat is that regulators seek greater convergence in the “risk-weights- the majors are allowed to apply against the assets they hold relative to competitors. Across their home loan books, which account for 60 per cent of total assets, the majors get to use ultra-low riskweights of between 15 per cent and 20 per cent of the assets’ actual values. With the exception of Macquarie, all other banks are required to apply much higher 40 per cent riskweights.
As a consequence, the majors hold less than half the capital, and hence have more than twice the leverage, of most rivals, for every dollar of home loans sitting on their balance sheets.
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Source: http://www.afr.com/real-estate/residential/housing-banks-at-risk-of-significantovervaluation-20131108-ix058
Using your knowledge from the course and the article above, answer the following questions:
a. NAB shares just paid a dividend of $2.83. You expect the dividends to grow at 5% forever. The required rate of return on NAB shares are 8%. What is the price of NAB shares today? (5 marks)
b. What does a high P/E ratio say about investor expectations? Under what circumstances can a P/E ratio be “too high”? What are the P/E ratios currently for CBA, WBC and ANZ and what do these indicate about investor expectations? (11 marks)
c. Use P/E analysis and market data to estimate a price for NAB shares. Do you think this value is a correct valuation of NAB shares? Justify your opinion. (10 marks)
d. Based on your analysis in questions a) - d) do you think there is a “price bubble” in Australian banking shares at the moment? Justify your answer with theory and some research. (5 marks)
e. According to the article what will happen to bank share prices if EPS for the big four banks fall? As a result, what would happen to the banks’ Tier 1 and Tier 2 capital and therefore its capital ratio (CAR)? (7 marks)