Banks: Underlying ROTEs show where value lies

About the author:

Azib Khan
Author name:
By Azib Khan
Job title:
Former Senior Analyst
Date posted:
06 July 2021, 4:30 PM
Sectors Covered:

  • We expect stable asset quality, better-than-consensus net interest margins and a focus on absolute cost reduction to be supportive of sector return on tangible equity – and consequently sector P/NTA multiples – over our forecast period.
  • Australia and New Zealand Banking Group (ASX:ANZ) and Westpac Banking Crop (ASX:WBC) remain our two preferred exposures. Commonwealth Bank (ASX:CBA) remains least preferred on valuation grounds.

Underlying ROTEs point to value in ANZ and WBC

Our estimates of underlying return on tangible equity (ROTE) for each major bank support our view that Australia and New Zealand Banking Group (ASX:ANZ) and Westpac Banking Crop (ASX:WBC) offer the most compelling value of the major banks. While CBA’s underlying ROTE is superior to its peers, and while we continue to believe CBA is a relatively high quality bank, we believe CBA’s current P/NTA multiple is stretched in light of its underlying ROTE.

We believe the potential for absolute cost reduction for the sector over the medium term is real and we expect such cost reduction to be supportive of ROTEs over the medium term.

While the recent reinstatement of COVID-related lockdowns in many capital cities of Australia is serving to somewhat blur the outlook for asset quality, our base case remains that the major banks will keep their last reported collective provision coverage of credit risk weighted assets unchanged and we consequently expect the cost of risk (credit impairment charge as a percentage of gross loans) for the major banks to generally be ~4bps pa over our forecast period. We continue to believe that consensus is too pessimistic on this front.

We are also more optimistic than consensus on the outlook for net interest margins over our forecast period.

WBC’s dividend payout ratio guidance looks conservative

We believe WBC’s dividend payout ratio guidance of ~60-65% over the medium term is conservative.

Our analysis, in light of our estimated underlying ROTE, leads us to believe that WBC can sustain a payout ratio of ~65-70% over the medium term whilst neutralising its dividend reinvestment plans.

Capital management potential remains attractive

Whilst investor interest appears to be particularly focused on capital management potential for CBA, we continue to see capital management potential for each of the major banks over our forecast period.

In fact, the capital management potential for WBC in dollar terms – particularly after allowing for the potential sale of the life insurance business and Panorama platform – is not too dissimilar to the potential for CBA in our view. WBC’s capital management potential is also particularly exciting due to WBC’s relatively large franking credit balance.

We would not be surprised if National Australia Bank (ASX:NAB) waits for its AUSTRAC issue to be resolved before embarking on capital management.

ANZ remains our preferred major bank

ANZ remains our preferred major bank on a valuation basis. 

WBC is our second preferred exposure, however in terms of quality we rank WBC above ANZ.

NAB is closer to fair value and we expect the share price to remain under pressure in relative terms until the AUSTRAC issue is resolved.

While we continue to view CBA as a relatively high quality bank, we view the stock as expensive and consequently expect it to under-perform the other three major banks. Our target price for CBA is now (login to view).

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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