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Westpac Banking Corporation (ASX:WBC) Is Trading At A 24.17% Discount

WBC operates in the banking industry, which has characteristics that make it unique compared to other sectors. Understanding these differences is crucial when it comes to putting a value on the bank stock. Banks, for example, must hold certain levels of tiered capital in order to maintain a safe cash cushion. Focusing on factors such as book values, along with the return and cost of equity, may be beneficial for gauging WBCâ€™s intrinsic value. Below we will look at how to value WBC in a reasonably accurate and simple approach.

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Why Excess Return Model?

Two main things that set financial stocks apart from the rest are regulation and asset composition. The regulatory environment in Australia is fairly rigorous. In addition to this, banks usually do not hold significant portions of tangible assets on their books. This means the Excess Returns model is best suited for calculating the intrinsic value of WBC rather than the traditional discounted cash flow model, which has more emphasis on things like capital expenditure and depreciation.

How Does It Work?

The central belief for Excess Returns 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 above the cost of equity is known as excess returns:

Excess Return Per Share = (Stable Return On Equity â€“ Cost Of Equity) (Book Value Of Equity Per Share)

= (0.13% â€“ 8.5%) x A\$19.73 = A\$0.87

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 â€“ Expected Growth Rate)

= A\$0.87 / (8.5% â€“ 2.3%) = A\$14.22

These factors are combined to calculate the true value of WBCâ€™s stock:

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

= A\$19.73 + A\$14.22 = A\$33.95

This results in an intrinsic value of A\$33.95. Relative to the present share price of AU\$25.74, WBC is , at this time, undervalued. This means thereâ€™s an upside to buying WBC today. Valuation is only one side of the coin when youâ€™re looking to invest, or sell, WBC. Analyzing fundamental factors are equally important when it comes to determining if WBC has a place in your 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 WBC going forward? Our analyst growth expectation chart helps visualize WBCâ€™s growth potential over the upcoming years.
3. Dividends: Most people buy financial stocks for their healthy and stable dividends. Check out whether WBC is a dividend Rockstar with our historical and future dividend analysis.

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