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Banking Royal Commission and Bank Valuations
Has the Banking Royal Commission created a buying opportunity in shares of the big four?
In the 1990’s Australia adopted the four pillars policy, where the largest four banks at the time (Commonwealth, Westpac, National Australia and ANZ) were prevented from undertaking mergers or acquisitions with each other. Along with this policy came favourable regulatory conditions, which have enabled the competitive advantages of these four bank to become more entrenched over the subsequent decades.
The favourable regulatory conditions in turn created an expectation from policy makers that the big four would function in a socially responsible manner and the royal commission is being used as a stick to enforce this compact between government and banks. Despite some of the misdemeanours committed by these institutions governments need to be mindful of the vital role they play in the Australian economy. Indeed, when most global peers were focussed on collateralized debt securities, the big four stayed plain vanilla.
Despite Australian banking being relative straightforward in nature, some clear and present risks exists. Australia, like many western countries, has significantly inflated house prices. Sydney property is reporting a cash flow yield of only 2%. Increasing global bond yields and decrease in demand from Chinese nationals are two potential risks for Australian property. Australian banks are highly leveraged and part of the big four’s competitive advantage comes from applying generous mortgage risk weightings using internal ratings-based (IRB) methodology. The big four are able to hold less capital to cover bad loans than many global peers, increasing their return on equity, but also increasing their risk profile.
Banks can be thought of as a black box investment. It would be next to impossible to determine loan quality and risk for all bank holdings and hence a probabilistic valuation tool may be more useful. Earnings yield makes more sense than cash flow yield, and dividend size and coverage are alternative inputs.
The following model gives several scenarios with a probability weighting set loosely on historical outcomes for the banking sector as well as the risk factors mentioned above. Each of CBA, WBC, NAB and ANZ are assumed to have a franked up dividend yield of approximately 9% and an earnings yield of 8.3%, based on an average PE of 12. Note CBA may trade on a slight premium to these figures. Scenarios are run over a 10 year period and initial capital is set to 1. All dividends are reinvested.
Column 1
Column 2
0
Scenario 1 (5%)
Banking catastrophe: Assume catastrophe strikes the big four and they go broke eliminating all shareholder capital and paying no subsequent dividends. This would take a severe global and local crisis. Alternatively, the banks face severe disruption in addition to some of the above. (initial capital set to 0)
1
Scenario 2 (15%)
Banking crisis: Assume banks function as per normal for 5 years and then a local or international crisis emerges causing valuations to halve over the subsequent 5 years. In this period assume no dividends as capital raisings remove any gains from dividends in the last 5 years. Disruption in the industry could also have this effect. (5 years @ 9% p.a., divide value after 5 years by 2)
2
Scenario 3 (30%)
Banks perform poorly: Assume rise in bad debts, but banks are able to battle through producing returns equal to the current 9% yield, through a mixture of dividends and some retained earnings growing loan books. (10 years @ 9% p.a.)
3
Scenario 4 (30%)
Status quo: Assume banks continue as they have the last 5 years or so. Earnings will grow around the same rate as inflation and some growth in loan books due to retained earnings of around 2% after paying dividends. (10 years @ 12% p.a. as a result of 9% dividends 3% capital growth)
4
Scenario 5 (15%)
Banks increase earnings: Banks are able to increase earnings at 6% p.a. by cost cutting, loan book growth and or margin expansion. (10 years @ 15% p.a. as a result of 9% dividends 6% capital growth)
5
Scenario 6 (5%)
Banks thrive: By using technology banks cut costs, the Australian economy grows strongly and/or margins expand. (10 years @ 19% p.a. as a result of 9% dividends 10% capital growth)
Note there are many other scenarios which could play out and the risk weightings are the author’s opinion. A small change in weightings or expected return can have a large impact on valuation.
Probability distribution table
Column 1
Column 2
Column 3
0
Pr(X=x) probability of event
Working out of return
E(x) expected value working
1
0.05
All capital lost
0 * 0.05 = 0
2
0.15
(1.09)5/2 = 0.77
0.77 * 0.15 = 0.116
3
0.3
(1.09)10 = 2.38
2.38 * 0.3 = 0.714
4
0.3
(1.12)10= 3.11
3.11 * 0.3 = 0.933
5
0.15
(1.15)10= 4.05
4.05 * 0.15 = 0.608
6
0.05
(1.19)10= 5.69
5.69 * 0.05 = 0.285
E(x) = 0 + 0.116 + 0.714 + 0.933 + 0.608 + 0.285
E(x) = 2.656
Applying this expected return to capital would mean $10,000 grows to $26,560 over the 10 year period.
To find the p.a. rate:
Solve (1 + x)10 = 2.656
x = 0.1026 or 10.26% p.a.
Note all of the above returns include franking credits being reinvested in full and many individuals tax situation would preclude them from doing so.
Conclusion:
A 10% p.a. expected return is very attractive in the current low interest environment. An inflation adjusted return would be somewhat lower. Obvious risks around home loan defaults, changing competitive environment or compensation claims need to be considered. Despite these negatives the big four valuations are attractive enough to allocate some space in a well balanced portfolio. With banks leveraged to the domestic economy, adding companies with overseas earnings or domiciled overseas may act as a foil to the big four valuations.
Disclosure: Westpac Bank, Macquarie Bank and Lloyds Bank (LSE:LLOY) are held in portfolios managed by the author of this article.
WBC Price at posting:
$29.18 Sentiment: Buy Disclosure: Held
(20min delay)