Westpac Banking Corp (ASX: WBC) shareholders haven't had the greatest year, so far. In fact, Westpac shares have underperformed the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) by 11% this year.
And with shares underperforming the market, no doubt, some investors will be wondering if Westpac shares are ridiculously cheap?
How we can value Westpac
Firstly, it is always important to remind ourselves that blue-chip shares like Westpac will rarely fall into 'bargain territory'. Indeed, for any blue chip company, let alone one with a market capitalisation of $102 billion, there is usually a swarm of analysts documenting the company's every move day-in-day-out.
That means it's usually only during times of severe market dislocation that shares of companies like Westpac will trade significantly below their fair value.
Nonetheless, not every investor has capital growth as a priority. Therefore, it can be useful to value some companies on the basis of the income they produce.
With a forecast payment of $1.88, Westpac shares yield a dividend equivalent to 6.2% at today's prices. Together with its franking credits, the comparable dividend yield blows out to an impressive 8.8% — try getting that from a term deposit!
However, according to traditional investment theory, we must discount those dividends by a required rate of return, and adjust for any growth. It's a relatively simple process.
Westpac's return on equity (ROE) gives us part of the growth equation (perhaps you can now see why banks always trumpet their ROE in media presentations!) and I'll choose a somewhat arbitrary required rate of return of 10% — similar to the expected return of the share market over the ultra-long-term.
Plugging those numbers into my dividend discount model (DDM) renders a value of $28.77.
Cheap or not?
Bearing in mind this is a very simple (though frequently used) measure of value, Westpac's current market price of $30.37 is above the model's estimated worth at $28.77. A slight overvaluation doesn't make it a sell, but perhaps adds to the case that it isn't a bargain at today's levels.
Foolish takeaway
With increasing regulation and competition in the domestic banking sector, I would not be a buyer of any bank shares, including Westpac, unless they were meaningfully undervalued. Moreover, though its dividend yield is very tempting in a low-interest rate environment, I'm looking for other dividend stock ideas to add to my portfolio.
