2023-11-04 02:06:59 ET
Summary
- Poor investor sentiment has crushed Scotiabank over the past decade.
- Scotiabank is undervalued relative to competitors with similar business models and target markets.
- Intrinsic Value: $69.
Investors should buy shares of The Bank of Nova Scotia (BNS). The firm, commonly known as Scotiabank, has had a rough 2023. Down 9% year-to-date , Scotiabank's executives has had to make some tough decisions, including a recent 3% workforce reduction. However, the firm's financial results have remained reasonably strong. Value and dividend-conscious investors may also be excited to hear that Scotiabank pays a 7% dividend yield.
Catalysts and Outlook
There are several important factors that investors should consider prior to purchasing Scotiabank shares:
1. Deposit Growth
Scotiabank's Q3 2023 Investor Presentation provides many insights into the firm's operational and managerial objectives. Deposit growth is an important component to Scotiabank's operations and has been decidedly positive over the past year. More deposits generally improve the company's ability to make loans and earn income.
While past growth rates of 11% year-over-year in Canadian Banking and 18% year-over-year in International Banking are encouraging, these historical metrics may not tell the future. During Scotiabank's Q3 2023 Earnings Call , Daniel Llewellyn Roes, the firm's Group Head of Canadian Banking, provided key insight into Scotiabank's plans to foster continued deposit growth. He said, "we launched in Q3 a really important pilot to deepen the deposit cross-sell off mortgages at time of origination. So I mean we're being very intentional here as we signaled a number of quarters ago, and we're really pleased with the cost of that deposit growth."
If Scotiabank can continue effectively cross-selling various products, then the firm should see additional deposit growth. Moreover, it would be desirable if the firm could further grow its personal deposits in order to capitalize on different market segments.
2. Commercial Real Estate
Many analysts believe that a commercial real estate crisis is imminent, and many regional banks, including Scotiabank, have significant CRE portfolios. Moreover, the combination of rising interest rates and work-from-home trends makes office and retail properties particularly susceptible to a downturn. Scotiabank does not have a high exposure to office and retail, but the properties that it is exposed to are geographically distributed across the world.
Scotiabank has reported a slight uptick in net write-offs, mainly due to retail properties in China. Investors can reasonably expect this trend to continue, and it is the responsibility of Scotiabank's management to find ways to ameliorate this issue.
3. Interest Rate Sensitivity
The monetary policies of multiple countries have important effects on Scotiabank's operations. Canada, Mexico, Colombia, Peru, Chile, and the United States have engaged in a series of rate hikes over the past year. The cumulative result of these hikes has been a decrease in Scotiabank's net interest income. Many banks have benefited from rising rates, but Scotiabank's balance sheet has characteristics that make it more sensitive to interest rate risk.
Many analysts seem to believe that rates will decline by the end of 2024. However, the actions of various central banks are hard to predict. Further rate hikes will continue damaging Scotiabank's operations. Moreover, the firm's lending policies have been affected by rising rates, with Daniel Llewellyn Ross commenting "we're just being more disciplined with regards to customer selection at time of origination. I think this is a good time to drive that standard higher here because it's a softer, slower housing market."
Valuation
Companies in different industries require distinct valuation methods. While a discounted cash flow model may be appropriate for firms in high-growth industries, banks are generally valued based on balance sheet multiples. Issues with U.S. GAAP accounting are partially to blame for this distinction, but this is remedied by the fact that the majority of a bank's assets are carried on the balance sheet at their fair values. Therefore, Scotiabank was valued through a combination of a peer group price to tangible book value multiple and a dividend discount model.
Scotiabank's peer group was selected with respect to market capitalization, geographic distribution, and total deposits. Based on these characteristics, a comps list of U.S. Bancorp (USB), Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM), Toronto-Dominion Bank ( TD ), Royal Bank of Canada ( RY ), and National Bank of Canada (NTIOF) was used to value Scotiabank. Using net interest margin, return on assets, tier 1 capital, and price to tangible book value data, the average and median of these values for the peer group was calculated to provide a good relative comparison to Scotiabank. The 1.6 times price to tangible book value peer multiple implies that Scotiabank is worth $54 per share instead of $41. However, multiples valuation alone is not sufficient to prove whether a firm is fairly valued since forming a peer group is quite subjective.
A dividend discount model was used to find the firm's intrinsic value. Scotiabank has a history of paying dividends to shareholders, and these cash flows were used to value the firm. The inspiration for using a DDM was taken from David B. Moore, a CFA with Marathon Capital Holdings in San Diego, California. Mr. Moore published a guide on valuing community banks whereby he argues the merits of using a DDM to price bank stocks.
Based on the firm's future discounted dividends, Scotiabank has an intrinsic value of $68 per equity share. This can be further amended to a target range of $58 to $82 per share, which implies significant upside. With respect to assumptions included in the base-case model, a 10% discount rate was used in addition to earnings and dividends estimates taken from Capital IQ. Moreover, a second-stage growth rate of 1% was used along with a terminal price to earnings ratio of 10.5. Please remember that these are estimates and are meant to illustrate a reasonable base case that does not consider a significantly negative or positive event.
Summary
Scotiabank provides a good value opportunity for investors. Valued well below its peers, Scotiabank has a reasonable margin of safety. Moreover, an intrinsic value of $68 provides investors with the potential for significant upside.
Scotiabank is not inherently different from many of its competitors. However, it still has a growth runway via commercial banking opportunities in the United States and capital markets abroad. This investment is a bet in the inherent quality of one of Canada's biggest banks that is often overlooked in favor of Toronto-Dominion Bank ( TD ) and Royal Bank of Canada (RY).
For further details see:
Scotiabank's Attractive Valuation