I did not buy FTSE 100 banking giant NatWest (LSE: NWG) for its long-term passive income potential. Passive income is money made with little effort, of which I am a big fan.
I bought it because it looked extremely undervalued to me, which it still does, despite big price gains over the past couple of years.
Sometimes, though, you can stumble into a stock that offers the rare combination of both. And I think this is one example of that.
So should I buy more now?
Big undervaluation
NatWest still looks very undervalued against its competitors. Its 9.4 price-to-earnings ratio is bottom of this group, which averages 14.3. These firms comprise Barclays at 11.3, Standard Chartered at 12.7, Lloyds at 14.6, and HSBC at 18.6. So it is cheap on this basis.
It is a bargain too at its 3.2 price-to-sales ratio compared to the 3.5 average of its competitors.
To ascertain the price at which it ‘should’ be trading — that is, its ‘fair value’ — I ran a discounted cash flow (DCF) analysis. This uses analysts’ growth forecasts for a firm to project future cash flows, which are discounted back to today.
Some DCF modelling is more bearish than mine, and some more bullish. However, using a 7.5% discount rate and a stable return on equity of 14.3%, my DCF suggests NatWest is 46% undervalued at its current £6.08 price.
That implies a fair value of £11.26 — close to double where it is trading today.
This price-to-valuation gap is crucial for long-term investors, as asset prices can gravitate towards their fair value over time. So it suggests a potentially superb buying opportunity to consider today if those DCF assumptions prove accurate.
High dividend yield
The prospect of such gains is terrific, although a risk is increasing competition in the sector that may squeeze NatWest’s margins. However, I am even happier now that I am receiving much higher dividends than I expected while I wait.
The bank’s current dividend yield is 3.5%. This is better than the present FTSE 100 average of 3.1%. But it is nothing much compared to the 7%+ I expect from my high-yield stocks.
I expect this, as I can get 4.5% from the ‘risk-free rate’ (10-year UK gilt yield). So anything over that I see as compensation for taking the extra risk involved in investing in shares.
Crucially, though, analysts expect NatWest’s dividend yield to rise to 5.6% this year, 6.2% next year, and 6.4% in 2028! This still does not quite meet the 7%+ minimum I usually look for with high-yield shares. But on the other hand, the potential for serious share price gains more than makes up for this.
How much dividend income?
My £20,000 holding in NatWest could make £17,865 in dividends after 10 years and £115,725 after 30 years.
This assumes the 6.4% forecasts dividend yield, although it could go lower or higher over time. It also reflects the dividends being reinvested into the stock to harness the magic of ‘dividend compounding’.
By the end of 30 years, my holding could be worth £135,725. And this could be paying a yearly dividend income of £8,686!
Given this rare combination of potential share price gains and high passive income while waiting, I will buy more NatWest shares soon.
