Stock Analysis & Ideas

# Is Royal Bank of Canada’s Stock Undervalued?

Story Highlights

RY is one of the strongest banks in the world and appears to be trading at a discount, as both analyst estimates and the excess returns valuation model suggest that there is upside potential.

Royal Bank of Canada (TSE: RY) (RY) is Canada’s largest bank in terms of market capitalization. It provides banking and financial services across Canada, the United States, and other selected countries.

It operates through the following segments: Personal and Commercial Banking, Wealth Management, Insurance, Investor and Treasury Services, Capital Markets, and Corporate Support.

RY’s share price is down roughly 3.6% year-to-date but up approximately 4.6% in the past year (not including dividends). Nevertheless, it may be undervalued at the moment despite its rebounding in the past few weeks.

## Valuation

To value RY, we will use the excess returns model. This approach is more appropriate for financial companies because they tend to have volatile free cash flows.

Because of this, trying to create forecasts for them is unproductive. The excess returns model allows us to use historical numbers instead, which are actual results. There are a few steps to follow for this valuation method.

First, you calculate a company’s excess returns. Next, you calculate the terminal value. Add them up, and you get your valuation. Here’s how it works:

Excess Return = (Average ROE – Cost of Equity) x Book Value Per Share
Terminal Value = Excess Return / (Cost of Equity – Growth Rate)
Fair Value = Book Value Per Share + Terminal Value

I will use the following assumptions for my calculations:

Average ROE: 16.6% (five-year average)
Cost of Equity: 7.9%
Book Value: C\$68.87
Growth Rate: 3.16% (used 30-year Government of Canada bond yield as a proxy for long-term growth expectations)

Now that I have my assumptions, let’s plug them into the formulas:

C\$5.99 = (0.166 – 0.079) x C\$68.87
C\$126.37 = C\$5.99 / (0.079 – 0.0316)
C\$195.24 = C\$68.87 + C\$126.37

As a result, RY is currently worth C\$195.24 per share under current market conditions.

## Dividend

For income-oriented investors, RY pays a 3.88% dividend yield on an annualized basis. When taking a look at RY’s historical dividend yield, you can see that it has remained relatively flat:

At 3.88%, the current yield is on the low end of the range, indicating that income-oriented investors are paying a premium relative to yields they have been able to receive in the past.

## Analyst Recommendations

Royal Bank of Canada has a Moderate Buy consensus rating based on six Buys and three Holds assigned in the past three months. The average Royal Bank of Canada price target of C\$146.55 implies 11.1% upside potential.

## Final Thoughts

RY is one of the strongest banks in the world and appears to be trading at a discount, as both analyst estimates and the excess returns valuation model suggest upside potential. As a result, investors may want to consider RY for their portfolios.

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