I purchased H-shares of the Bank of China (BOC) for my Dividend Income Portfolio. Here are the reasons why.

Summary

In this article, I examine the stock valuation of the H-share of Bank of China (BOC 3988.HK) through the eyes of a Dividend Investor. Dividend Cash Flow analysis was used to evaluate Bank of China's H-share (BOC 3988.HK). The Dividend Discount Model was employed to calculate the H-share Intrinsic Value, Expected Return on Investment, and its Margin of Safety.
Continue reading to learn more.

Introduction

Following my previous article on the H-shares of the Industrial and Commercial Bank of China (ICBC), I also recently purchased the H-shares of the Bank of China (BOC). Here, I would like to discuss the rationale behind the investment decision to add the H-shares of BOC for my dividend income portfolio.

Over the years, my approach to investing has evolved from the speculative growth and momentum style to a more conservative method, preferring stocks which provide attractive dividend income streams at inexpensive valuations. I used the following set of questions to help determine the investment worthiness of the H-share of the Bank of China (BOC):

• • Does the Bank of China (BOC) have a good long-term dividend track record?

• • Does the Bank of China (BOC) currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

• • Is the current payout ratio of the Bank of China (BOC) sustainable?

• • What is the expected return on investment of the Bank of China (BOC) over a 10-year period? Majority of recommendations by financial analysts tend to have a 12 month time horizon. I find the 10-year period to be more suitable for a dividend income stock, especially one which is part of a retirement dividend income portfolio.

• • Does the H-share of the Bank of China (BOC) offer a sufficient margin of safety to the intrinsic value of the stock?

• • Are the H-shares of the Bank of China (BOC) considered attractive when measured against the traditional value investing yardsticks? A good dividend stock with inexpensive valuation will minimize the risk of capital impairment and increase the probability of capital gains.

With the above questions in mind, let us delve into the analysis of the Bank of China (BOC) to find the answers.

Background Information on the Bank of China (BOC)

Bank of China (BOC) was founded in February 1912 and is the oldest commercial bank in China. It is currently the fourth largest commerical bank in China and also in the world in terms of assets.

Bank of China’s largest shareholder is the Central Government of China which controls over 67% of the voting rights through multiple state-owned entities, the biggest one being Central Huijin Investment Ltd (64.02%). Hence, Bank of China (BOC) is considered to be a state-owned commercial bank and is one of the largest state-owned enterprise in China.

Does the Bank of China (BOC) have a good long term dividend track record?

Bank of China (BOC) has an uninterrupted track record of dividend payments since its dual listing on the Hong Kong Stock Exchange and the Shanghai Stock Exchange on June 1st and July 5th 2006 respectively.

Data Source: Bank of China Annual Reports

In addition to its impressive history of dividend payments to shareholders, Bank of China’s dividend per share has also increased steadily from 0.10RMB per share in FY2007 to 0.197RMB per share in FY2020, growing at a compounded annual growth rate of 5.35%.

Further evidence of the Management’s commitment to rewarding its shareholders, Bank of China (BOC) continued to pay a full dividend in the year 2020, a year in which the world economy was severely affected by the Covid-19 health crisis. In the same year many banks around the world, including European banks and American banks were forced to severely reduce or eliminate their dividend payments. This is testimony to Bank of China’s excellent dividend track record since its public listing in 2006.

Does Bank of China (BOC) currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

For FY2020, Bank of China (BOC) declared dividends of 0.197RMB per ordinary share, which is equivalent to 0.2376HK$. On 20th August 2021, the H-share of Bank of China (BOC) closed at 2.70HK$ per share. This translates into a dividend yield of 8.80% which is substantially higher than the average dividend yield of the constituent stocks of Hang Seng Index.

Data Source: AAStocks.com

Is the current payout ratio of Bank of China (BOC) sustainable?

In the last 6 years (FY2015 to FY2020) the dividend payout ratios of the major China Banks, including that of Bank of China (BOC), have stabilized at around the 30% to 30.5% level.

Data Source: CGS-CIMB Report on China Banks dated 28 July 2021

CGS-CIMB, in their report on China Banks titled “In Dividends We Trust” dated 8th April 2020, put forward 6 reasons why the dividend payout ratios of the large Chinese State-Owned commercial banks are considered to be sustainable at current levels (Quoted verbatim from page 7 of the said report):

1. 1. Ownership structure of these large banks, and the importance of their dividends to central government revenues.

1. 1. Regulatory reasons which may discourage the banks from making large cuts to the payout ratios, with special significance around the 30% level.

1. 1. The large China banks' 30% dividend payout ratio levels are by no means aggressive, and are well below the global bank median.

1. 1. Capital ratios look more than adequate for the large banks relative to minimum regulatory requirements.

1. 1. Dividend payout ratio cuts do not save much Tier 1 capital, so there is little point in slashing the dividend payout to save capital.

1. 1. Slower loan growth as well as continued shift in loan book mix towards retail and away from corporate going forward means less pressure on capital, even after factoring in the falling pace of organically generated capital. Falling provisioning coverage ratios for some of the mid-large banks could also boost core Tier 1 ratios.

The above 6 reasons given by CGS-CIMB make a strong case for the sustainability of the dividend payout ratio of Bank of China (BOC).

What is the expected return on investment for Bank of China (BOC) over a 10-year period?

A cash flow analysis was carried out to determine a reasonable estimate of the expected return on investment for Bank of China (BOC) H-share over a 10-year period. The Dividend Discount Model was adopted. Key parameters for the cash flow model are as follows:

1. 1. Period = 10 years

1. 1. Terminal growth rate = 3%

1. 1. Risk-Free Rate = 0.94% (Risk-Free Rate for July 2021 according to Market Risk Premia)

Data Source: market-risk-premia.com

4. 4. HK Stock Market Risk Premium = 10.5% (Approximately equal to the Market Risk Premium at the depths of 2008 Global Financial Crisis according to Market Risk Premia)

Data Source: market-risk-premia.com

5. 5. Bank of China (BOC) Stock Beta = 1.0
      • • This is a conservative estimate. According to the Financial Times, the beta is around 0.81. Furthermore the beta for the major China commercial banks have been consistently dropping as can be shown in the graph below, provided by CGS-CIMB in their report dated 28th July 2021.)

Data Source: CGS-CIMB Report on China Banks dated 28 July 2021

7. 7. Currency Exchange Rate = 1.20 HK$/RMB

7. 7. Discount Rate = Risk Free Rate + Beta x Market Risk Premium = 0.94% + 1(10.5%) = 11.44%

From the above cash flow model, the following values are calculated:

1. 1. Total of Discounted Dividends (FY21 to FY30) = 1.287RMB

1. 1. Expected Price to Book Value Ratio in FY30 = (ROE-g)/(K-g) = (7.95%-3%)/(11.44%-3%) = 0.586

1. 1. Expected Book Value of Bank of China (BOC) in FY30 = 11.18RMB

1. 1. Expected Stock Price in FY30 = 0.586 x 11.18 = 6.55RMB

1. 1. Present Value of FY30 Stock Price = 6.55/(1.1144)^10 = 2.219RMB

1. 1. Estimated Intrinsic Value of Bank of China (BOC) = 1.287 + 2.219 = 3.506RMB which is equal to 4.207HK$ per share.

Based on the discounted cash flow model, the intrinsic value of the H-share of Bank of China (BOC) is estimated to be approximately 4.207HK$ per share when discounted at the rate of 11.44% per annum.

One way to interpret the results above is that an investment into the H-share of Bank of China (BOC) at a price of 4.207HK$ is expected to provide a return on investment of 11.44% per annum over a 10-year period.

The goal seek function of Excel can be used to find a discount rate that will yield an intrinsic value equal to the purchase price of 2.70HK$. This discount rate is found to be equal to 14.99%. In other words, an investment into the H-share of Bank of China (BOC) at a price of 2.70HK$ is expected to provide a return on investment of 14.99% per annum over a 10-year period.

Does the current stock valuation of Bank of China (BOC) offer a sufficient margin of safety?

On 20th August 2021, Bank of China (BOC) H-share price closed at 2.70HK$ per share. With an estimated intrinsic value of 4.207HK$, this translates into a comfortable margin of safety of 35.82%.

Are the H-shares of Bank of China (BOC) considered inexpensive when measured according to traditional value investing yardsticks?

Some popular yardsticks to gauge the value of stocks as investments include the Price to Earnings ratio and the Price to Book Value ratio. In this section we will see how the H-share of Bank of China (BOC) measures up against these benchmarks. Based on the Bank of China (BOC) H-share price of 2.70HK$ per share, the following observations are made:

• • Trailing PE Ratio:
    • • EPS FY2020 = 0.61RMB = 0.732HK$
    • • PE = 2.70/0.732 = 3.69
    • • The price represents an opportunity to own a stake in one of the largest commercial bank in the world, in terms of assets, at an attractive discount with a payback period of less than 4 years.

• • PBV Ratio:
    • • Book Value FY2020 = 5.98RMB = 7.18HK$ per share
    • • PBV = 2.70/7.18 = 0.376
    • • The Return on Equity of Bank of China (BOC) in FY2020 is 10.60%. Using a discount rate of 11.44% and a growth rate of 3%, the expected PBV can be estimated to be 0.90. Applying a 30% discount to this estimated value implies a fair PBV of 0.63. This represents an upside of 67.5% from the current PBV of 0.376.

In addition, Bank of China (BOC) has a consistent track record of positive earnings since its public listing and the historical earning per share from Fiscal Year 2007 to 2020 are as tabulated below. It is worth noting that from 2010 to 2020, the earnings per share of Bank of China (BOC) grew at a compounded annual growth rate (CAGR) of 4.57%.

Data Source: Bank of China Annual Reports

Conclusion

In this article, I set out to document the rationale behind my recent investment decision to purchase the H-shares of Bank of China (BOC) for my dividend income portfolio. The many reasons I found Bank of China (BOC) H-share to be an attractive investment can be summarized as follows:

1. 1. Bank of China (BOC) has a good long-term dividend track record.

1. 1. Bank of China (BOC) currently offers an attractive dividend yield which is higher than the average yield of Hang Seng Index constituent stocks.

1. 1. The current payout ratio of Bank of China (BOC) is sustainable.

1. 1. An investment into the H-share of Bank of China (BOC) at a price of 2.70HK$ is expected to provide a return on investment of 14.99% per annum over a 10-year period .

1. 1. The intrinsic value of Bank of China H-share is estimated to be 4.207HK$ per share, representing a 35.82% margin of safety over the price of 2.70HK$.

1. 1. The H-shares of Bank of China (BOC) are currently trading at inexpensive valuations when measured against traditional value investment yardsticks.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.