What's wrong with this sentence: Is the National Australia Bank Ltd. (ASX: NAB) share price cheap?
Price versus Value
The question is asking if the price is cheap, without considering its worth. That's what is wrong.
Valuation allows us to understand what something — like NAB shares — is worth.
If we do not run some type of valuation we have no way of knowing if something is cheap because we cannot compare the price to value.
Everyone knows the price of everything, but the value of nothing
I can all but guarantee that if you ask 10 NAB shareholders how much their shares are worth, nine of them wouldn't know. But, in an instant, I would be willing to bet that they all could tell you the price of NAB shares.
Heck, even if you ask a 'professional' investor, your mate's monkey's uncle or "#RogueTrader" in an online stock forum, I would be willing to bet the majority of them wouldn't know, either. But, they would probably point to a chart like this:
Like I said, most of us get the 'price' part right — just look it up in Google.
But, when it comes to the 'value' part most of us have no idea where to begin.
Many of us will look at online analyst price targets (eww).
And you wouldn't be the only one…
Here's something you probably don't know: many professional investors (like fund managers) use those same reports — instead of valuing the shares for themselves!
2 valuation techniques
Below, I'm not going to tell you precisely how to value NAB shares (I'll be doing a video on that later this year). However, here's an overview of two techniques you can use to value NAB shares:
- Dividend Discount Model (DDM). As a bank, it's difficult to use a stock-standard discounted cash flow (DCF) analysis on NAB shares. That's where the DDM comes in. It uses a forecast of dividends to shareholders, then discounts the dividends back to today's dollars. Like all valuation methods, the math is pretty straightforward. The important bit is understanding how the bank goes from revenue received to paying dividends.
- "Comps". This is a simple one. It's also called a "Comparable Company Analysis" or CCA. As its name suggests, you could take a statistic from NAB, like its P/E ratio or P/B ratio, and then compare it to its peers like Westpac Banking Corp (ASX: WBC). You could also compare and value different divisions of NAB's business, like its business banking division or its financial planning arm.
Foolish Takeaway
When I assess a business, the actual valuation spreadsheet I create probably accounts for only 10% to 20% of the time I spend researching the company. Often, it is even less.
But for all this talk about valuation, I should say that value investing is an art and not only a science. For example, 2 + 2 = 4. But what you think a share is worth will be different to what I think it is worth.
Finally, consider this: 'If you have to put it in a spreadsheet – it's not cheap enough.'
