As has been evident at investor briefings in recent days, Australian banks appear to be conceding that their past relatively high (by global standards) returns on equity can’t be sustained, due to pressure on net-interest margins and increased capital requirements. That said, given the underperformance of banks over the past year or so – especially compared to other high yield sectors like listed property – this downward adjustment in profitability has arguably already been priced into valuations. At least on a relative basis, the Australian financials sector now appears good value, especially if long-term bond yields rise further. What’s more, concerns that new capital requirements could crimp bank dividend yields may be misplaced.
Banks “miss the boat”
As seen in the chart below, the Australian banking sector has underperformed other high-yielding sectors such as listed property over the past year or so. The decline in bank share price valuations since the peak in the Australian equity market in early 2015 is particularly notable. The recent underperformance of listed property – reflecting rising global bond yields – has so far only partly unwound the sector’s outperformance versus banks since early 2014.
As a result of this underperformance, the S&P/ASX 200 Banks (a sub-component of the Financials Index) as at end-October was trading at a price-to-book valuation of 1.7, or 20% below its average of 2.1 since 2003. By contrast, the S&P/ASX 200 REIT was trading at a price-to-book valuation of 1.2, or around 6% above its average of 1.16 since 2003. Note on an end-month basis, listed property reached a recent peak price-to-book valuation of 1.4 at end-July (24% above average), a valuation level not seen since prior to the global economic crisis.
Across the market more broadly, the relatively attractive valuation of the financials sector is also evident from this chart of price-to-forward earnings ratios contained in the Reserve Bank of Australia’s November Statement on Monetary Policy released last Friday. Unlike resources and other sectors in general, the financials sector is currently trading on a forward PE valuation no higher than its long-run average.
Higher interest rates favour banks over other “defensive yield” sectors
Note to the extent that global bond yields continue to rise over the coming year, this is more likely to hurt other so-called “defensive yield” sectors such as listed property and utilities, as their valuations (or “cap rates”) are largely tied to competing returns available from fixed-income securities. Banks, by contrast, may benefit to the extent higher long-term rates would allow them to improve net-interest margins by increasing the interest rates they can charge on some business and household loans – a benefit, we have noted, that also applies to global banks.
Indeed, while helping support credit demand, RBA rate cuts over the past year have also placed downward pressure on local bank net-interest margins, due to the banks inability to push already low deposit rates closer to zero, or even negative territory. Provided it does not overly crimp credit demand, an eventual modest lift in local official interest rates may help banks restore some of the recent erosion in interest-margins.
High capital requirements need not hurt long-run dividend yields
One concern with regard to the banking sector is that the regulatory demands for more capital could hurt returns on equity – and ultimately dividends. As seen in the chart below, capital ratios for major banks have lifted particularly sharply over the past year or so, reflecting around $27 billion in new equity from capital raisings and retained earnings.
For a given return on assets, the need to hold more capital or “equity” on the balance sheet should place downward pressure on return on equity – which is evident for the major banks in the chart below.
But does this mean dividend yields will also fall? Not necessarily. Indeed, finance theory tells us that to the extent a lower return on equity is reflected in a lower price-to-book valuation going forward, dividend yields can be sustained.
For example, the standard “Gordon dividend growth model” tells us that a company’s dividends per share (D) can be thought of as a product of its book value per share (BV), return on equity (ROE), and dividend payout ratio, as seen in the equation below
D = BV*ROE*payout ratio
Dividing through by the company’s share price, and re-working the equation tells that that the dividend yield (D/P), is related to ROE, price-to-book value (P/BV or PBV) and payout ratio, as follows.
D/P = ROE*payout ratio/(PBV)Since mid-2005, for example, the S&P/ASX 200 Banking index has averaged a return on equity of around 16%, with a payout ratio of around 75% and a price-to-book value of 2.1. This resulted in a net dividend yield of around 5.7%. Assuming, due to pressure on profit margins and higher capital requirements that bank return on equity going forward only averages, say 12%, then a dividend yield of 5.7% could still be preserved if price-to-book valuations fell to around 1.6, which is not far from current levels.
In other words, to the extent the downward pressure on bank returns on equity are reflected in a downward adjustment in price-to-book value (as has been evident in the past year) then its possible for banks to preserve still relatively attractive dividend yields going forward – the price of which has already largely been paid for by existing shareholders through having had to endure some downward adjustment in valuations.
On this view, banks on a price-to-book value basis might now be closer to “fair-value” than cheap, even though valuations by this metric are now somewhat below their long-run average. Relative to other sectors of the market, however, banks are arguably better value – especially compared to “defensive yield” sectors such as listed property, utilities and telecommunication in an environment of rising bond yields.