Why NAB is suddenly more attractive

Brokers are changing their discount cash flow assumptions toward banks in response to lower interest rates.

Australian bank stocks – led by National Australia Bank (NAB) – suddenly just got better as lower interest rates change the way brokers evaluate the sector.

CIMB Securities upgraded its sector view on banks this week to “neutral” from “underperform”, finding between 10% and 12% of extra value in the main banks and between 6% and 9% for the regionals despite leaving its earnings and dividend forecasts unchanged.

The biggest beneficiary among the banks was NAB as CIMB upped its rating on the stock from "neutral” to the highest rating of "outperform" on top of the price target lift of 10% to $35.02 (The stock is currently trading at $32.62 at 1118 AEST).

Why NAB has become much more attractive is due to valuation changes which shift the bank’s expected returns to 5% above the S&P/ASX 200 over the next 12 months – the 5% threshold is what separates "neutral" from "outperform".

At the heart of the added allure for bank stocks for brokers is a change in the all-important discount rate. CIMB lowered the risk-free interest rate used in its discount cash flow (DCF) assumptions to 4.25% from 5.25% in response to weaker than expected interest rates.

Moreover, the broker says it expects these lower rates to remain in place in Australia for some time.

“The fall in this rate since the global financial crisis means our previous risk-free rate of 5.25% is too high, which understated our valuations and target prices,” CIMB said.

Another change was the removal of discounts CIMB applied to its multiple-based valuations such as the price to earnings ratio, which also served to boost the target prices.

More evidence that the UK economic recovery is broadening also gave weight to the upgrade for NAB.