Undervalued stock of the week - NAB

November 26, 2012, 10:45 am John Abernethy Yahoo!7

The market looks to have overestimated the negative aspects of the bank's risk profile to a point that makes it now an attractive buy.

Value investing is a unique investing methodology because it often means going against natural instincts to buy companies that are out of favour, or that appear to be performing below par. A “buy” sign will flash when the share price falls far enough below its fair value even if, in absolute terms, we don’t think the company concerned is as strong as some others in its field.

National Australia Bank is a case in point. In many ways, NAB is perhaps the least attractive of the big banks. It has the lowest provisioning for bad debts (which may leave it vulnerable if the economy takes a turn for the worse), it is the least profitable compared to its big bank rivals, and it’s average return on equity, while pretty good at 14.2 per cent, is the least impressive among its peers.

In addition it has issues with its UK and US operations which are acting as a drain on its profitability, and means it has a structural disadvantage compared to other banks.

However, its share price is now trading at such a level that all of this appears to be factored in. Indeed, we think that these factors have led the bank to be sold off to well below its fair value.

We have a valuation of $29.19, which gives investors a potential upside of 23 per cent – a bigger potential profit than with any other big bank. And the required return on equity – the key measure we use to determine whether a company can achieve our valuation – is well within its historical average range at just over 12 per cent.

Crucially, NAB is also paying a handsome dividend of 7.5 per cent, or 10.7 per cent once grossed up to take account of franking credits.

Remember, NAB is still part of one of the strongest banking sectors in the world. Generally speaking, the banking sector is doing well: our banks have a market capitalisation of $300 billion and reported profits of $23.6B in 2012. Although this was a small decline on the previous year (-4.0%), current expectations are for banking sector profits to increase +10% in 2013, and dividends are also expected to rise – NAB’s included.

No company is perfect. Value investing is about spotting when the market has over-egged the negative aspects of a company’s risk profile to a point that makes it an attractive buy. We think that time has come for NAB, and for investors willing to take on some risk in the banking sector, NAB could prove to be an excellent play.

Company: NAB
Current price: $23.63 (26th November)
Forecast value: $29.19 and above ++

Potential upside: 23.5%

Readers of Yahoo!7 Finance can obtain a free 14-day trial offer of the MyClime online share valuation and research service at www.clime.com.au.

Investors should not rely on this information alone and should seek independent financial advice from a qualified expert before considering any share market investment.

++Fair or forecast value is the price placed on the share after calculating a range of factors including profitability, assets, debt and, most importantly, Return on Equity – the same measure used by Warren Buffett to assess long-term value.

Shares are assessed by Clime Asset Management to calculate which companies are undervalued or over-valued based on their return on equity. History has shown that the most successful companies are those that produce the highest returns per dollar of shareholders' equity, yet this is not typically how shares are valued. This system highlights shares that are undervalued on this key measure. Shares are expected to reach this value in 3-5 years, as price tends to follow value in time.

Information is intended as a guide only. For specific advice contact your financial services professional.

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