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The BOQ stock price is approaching $7, here are 2 methods to evaluate it

Right now you can probably use Google or another data provider to see the the price of Bank of Queensland Limited (ASX: BOQ) is around $7 per share. But what are BOQ shares really worth?

Getting a valuation is one of the most popular questions or topics our senior investment analysts receive from Australian investors, especially those seeking dividend income. It’s not exclusive to Bank of Queensland Limited, of course.

Bendigo & Adelaide Bank Ltd (ASX:BEN) and Westpac Banking Corp. (ASX: WBC) are also very popular stocks on the ASX.

Before we go through two valuation models you could use to answer the question yourself, let’s take a look at why investors like bank stocks in the first place.

Alongside the technology and industrials sectors, the financial/banking sector is one of the favorites of Australian investors. The largest banks, including Commonwealth Bank of Australia and National Bank of Australia operate in an “oligopoly”.

And while major international banks, such as HSBC, have attempted to encroach on our ‘Big Four’, the success of foreign competitors has been very limited. In Australia, ASX bank stocks are particularly popular with dividend investors looking for postage credits.

Ratio Analysis

The price/earnings ratio or “PER” compares a company’s stock price (P) to its latest earnings per share (E) for the full year. Remember that “benefits” is just another word for profit. Therefore, the ‘P/E’ ratio simply compares the stock price to the company’s most recent annual earnings. Some experts will try to tell you that “lower PE ratio is better” because it means the stock price is “low” relative to the earnings generated by the company. However, stocks are sometimes in the money for a reason!

Second, some extremely successful companies have operated for many years (a decade or more) and never reported a book profit – so the PE ratio wouldn’t have worked.

Therefore, we think it’s worth digging deeper than just looking at the PE ratio and thinking “if it’s below 10x, I’ll buy it”.

One of the simple ratio models analysts use to value a bank stock is to compare the PE ratio of the bank to the stock you are looking at with its peer group or competitors and try to determine if the stock is unreasonably high or undervalued compared to the average. From there, and using the principle of mean reversion, we can multiply earnings/earnings per share by the industry average (E x sector PE) to reflect what an average company would be worth. It’s like saying, “If every other stock has the price of ‘X’, so should this one.”

If we take BOQ’s stock price today ($7.31), 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 14.3x. This compares to the banking industry average PE of 24x.

Next, take the earnings per share (EPS) ($0.511) and multiply it by the industry average PE ratio of BOQ (Banking). This translates to a “sector-adjusted” PE valuation of $12.06.

Beyond BOQ’s dividend yield

The Dividend Discount Model or DDM is different from the valuation of ratios like the PE because the model forecasts into the future and uses dividends instead of profit. 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 dividend improvement (eg 2%) and the risk level 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 easy to understand, we will assume that last year’s dividend payment ($0.12) climbs at a constant rate in the future at a fixed annual rate.

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 an average dividend growth rate and a risk rate between 6% and 11%.

This simple DDM valuation of BOQ stock is $2.29. However, using an “adjusted” dividend payment of $0.00 per share, the valuation changes to $0.07. The expected dividend valuation compares to Bank of Queensland Limited’s share price of $7.31. 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 ($0.01), our BOQ stock price valuation is forecast at $0.10.

More research

Please keep in mind that these valuation methods are just the starting point of the research and evaluation process. Please remember this. Banks are very complex businesses and if the 2008/2009 GFC taught investors anything, it was that even the “best” banks can fail and drag shareholders down with them.

If you are reviewing Bank of Queensland Limited shares and considering an investment, take the time to learn more about the bank’s growth strategy. For example, is it 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. Finally, it is always essential to do an assessment of the management team.