Undervalued stock of the week: Westpac

October 22, 2013, 12:41 pm John Abernethy Yahoo7

Value shares are hard to find, but the bank is beginning to register again as a good opportunity.

Company: Westpac (WBC)

Share price: $33.21

Future value: $35.47

Potential upside: 6.8% in 2014

With the stock market still near its record highs, value shares are hard to find. And with interest rates sliding steadily downwards, preserving the value of your cash is becoming more and more challenging.

Investors therefore face a dilemma: opt for the “safety” of a savings account that is most likely losing money once inflation is taken into account, or invest in shares, where the capital value is uncertain, but where yields can often provide a greater income than is available from cash deposits.

That’s partly why Westpac is beginning to register again as a good opportunity. It is a solid business holding up very well in a difficult market and maintaining a yield in excess of 5%, which is a far better than is on offer for savings accounts from most institutions, while still holding the possibility of capital growth over time.

Bank prices have increased lately, which has caused many to bring up the old argument that Australian banks are expensive compared to those overseas. Possibly they are, but comparison with banks across Europe are spurious, since many banks there are owned or underwritten by their governments, having all but collapsed during the GFC. Indeed many remain in perilous financial positions and in dire need of more capital. That is not the case in Australia.

While shares in the big four are pretty fully valued, there is a plausible case for a higher valuation of Westpac (than our current base case) in FY14. If you assume marginally improved operating performance, if the post-election uptick in consumer and business confidence is sustained, and lower your required return, based on an expectation of sustained QE and a low interest rate environment, then a FY14 valuation at close to $35 is reasonable. Under this scenario, WBC has a 2014 valuation of $35.47, which should come into focus if the 2013 result is as expected. I perceive a 10% return from this share over the coming 12 months and a continued increase in price thereafter.

Westpac has also completed the purchase of Lloyds Banking Group’s Australian assets for $1.45 billion. The deal incorporates Lloyds’ Motor Vehicle Finance Book of $3.9 billion, equipment finance book of $2.9 billion and a corporate loan portfolio of $1.6 billion, which together give the loan portfolio a face value of $8.4 billion.

Westpac expects to add $100 million in earnings and diversify its lending exposure away from home loans through the deal to acquire corporate loans and car and equipment finance assets totalling $8.4bn. On the face of it this increases risk and may mean dividends don’t grow as much as they might have, but yields will still be attractive and its focus on growth is encouraging – it will pay off very well if we see the economy recover in coming years.

Westpac is also relying less and less on expensive overseas funding for its mortgage book, which is a great sign, and it has a good record of managing its shareholders’ capital well, with an average return on equity of 20 per cent over the past five years. If that continues, WBC’s investors have a good chance of seeing a share price increase and good dividend despite a relatively flat domestic economy and so investors should be happy to hold it in their diversified portfolios.

++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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