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Bank of Montreal (TSE:BMO) Investors Are Paying Above The Intrinsic Value

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Bank stocks such as BMO are hard to value. This is because the rules banks face are different to other companies, which can impact the way we forecast their cash flows. Banks, for example, must hold certain levels of tiered capital in order to maintain a safe cash cushion. Focusing on line items like book values, along with the return and cost of equity, may be beneficial for computing BMO’s value. Below I’ll take you through how to value BMO in a reasonably useful and straightforward approach.

Check out our latest analysis for Bank of Montreal

What Model Should You Use?

There are two facets to consider: regulation and type of assets. BMO operates in Canada which has stringent financial regulations. Furthermore, banks tend to not have large amounts of physical assets on their books. Excess Returns overcome some of these issues. Firstly, it doesn’t focus on factors such as capex and depreciation – relevant for tangible asset firms – but rather emphasize forecasting stable earnings and book values.

TSX:BMO Intrinsic Value Export August 28th 18
TSX:BMO Intrinsic Value Export August 28th 18

How Does It Work?

The central belief for this model is, the value of the company is how much money it can generate from its current level of equity capital, in excess of the cost of that capital. The returns in excess of cost of equity is called excess returns:

Excess Return Per Share = (Stable Return On Equity – Cost Of Equity) (Book Value Of Equity Per Share)

= (13.78% – 10.0%) x CA$69.72 = CA$2.63

We use this value to calculate the terminal value of the company, which is how much we expect the company to continue to earn every year, forever. This is a common component of discounted cash flow models:

Terminal Value Per Share = Excess Return Per Share / (Cost of Equity – Expected Growth Rate)

= CA$2.63 / (10.0% – 2.3%) = CA$34.35

Combining these components gives us BMO’s intrinsic value per share:

Value Per Share = Book Value of Equity Per Share + Terminal Value Per Share

= CA$69.72 + CA$34.35 = CA$104.08

This results in an intrinsic value of CA$104.08. Given BMO’s current share price of CA$106, BMO is currently fairly priced by the market. Therefore, there’s a bit of a downside if you were to buy BMO today. Pricing is one part of the analysis of your potential investment in BMO. Fundamental factors are key to determining if BMO fits with the rest of your portfolio holdings.

Next Steps:

For banks, there are three key aspects you should look at:

  1. Financial health: Does it have a healthy balance sheet? Take a look at our free bank analysis with six simple checks on things like bad loans and customer deposits.

  2. Future earnings: What does the market think of BMO going forward? Our analyst growth expectation chart helps visualize BMO’s growth potential over the upcoming years.

  3. Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether BMO is a dividend Rockstar with our historical and future dividend analysis.

For more details and sources, take a look at our full calculation on BMO here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.