With the Commonwealth Bank of Australia (ASX:CBA) currently trading around $89.39, let’s run through two common share price valuation tools an analyst might use to provide his or her ‘target’ on an ASX bank share like CBA.
As you may know, this is the ‘easy’ or ‘simple’ version. But ‘easy’ doesn’t necessarily equal ‘good’. So, at the bottom of this article, we’ll provide some further resources to complement our potential indicative valuations. Basically, it goes without saying but these valuations are not guaranteed.
Bank shares like Commonwealth Bank of Australia, ANZ Banking Group (ASX:ANZ) and Macquarie Group Ltd (ASX:MQG) are very popular in Australia because they tend to have a stable dividend history, and often pay franking credits.
In this article, we’ll explain the basics of investing in ASX bank shares. But if you’re interested in understanding the value of dividend investing in Australia (i.e. the benefits of franking credits), check out this video from the education team at Rask Australia.
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Comparable valuations with PE
If you have been investing in direct shares for more than a few years you will have heard about the PE ratio. The price-earnings ratio or ‘PER’ compares a company’s share price (P) to its most recent full-year earnings per share (E). If you bought a coffee shop for $100,000 and it made $10,000 of profit last year, that’s a price-earnings ratio of 10x ($100,000 / $10,000). ‘Earnings’ is just another word for profit. So, the PE ratio is basically saying ‘price-to-yearly-profit multiple’.
The PE ratio is a very simple tool but it’s not perfect so it should only be used with other techniques (see below) to back it up. That said, one of the simple ratio strategies even professional analysts will use to value a share is to compare the company’s PE ratio with its competitors to try to determine if the share is overvalued or undervalued. It’s akin to saying: ‘if all of the other banking sector stocks are priced at a PE of X, this one should be too’. We’ll go one step further than that in this article. We’ll apply the principle of mean reversion and multiply the profits per share (E) by the sector average PE ratio (E x sector PE) to calculate what an average company would be worth.
If we take the CBA share price today, together with the earnings (aka profits) per share data from its 2020 financial year, we can calculate the company’s PE ratio to be 24.3x. That compares to the banking sector average PE of 25x.
We can take the profits per share (EPS) ($3.68) and multiply it by the average valuation for CBA. This results in a ‘sector-adjusted’ share valuation of $91.73.
Using dividends as a proxy for CBA’s cash flow to equity investors
A DDM or dividend discount model is quite different from ratio valuations like PER because it makes you forecast cash flows into the future (it uses dividends as ‘cash flow’). Because the banking sector has proven to be relatively stable with regards to share dividends, the DDM approach can be used. However, we would not use this model for, say, technology shares.
Basically, we need only one input into a DDM model: dividends per share. Then, we make some assumptions about the yearly growth of the dividend (e.g. 2%) and the risk level of the dividend payment (e.g. 7%). We’ve used the most recent full year dividends (e.g. from last 12 months or LTM) then assumed the dividends remain consistent but grow slightly.
Let’s assume last year’s dividend payments are consistent over time. Please note that using dividends paid last year is not always a good input to a DDM since the future is what we care about (note: we’ve made adjustments below to handle this).
To make the DDM easy to understand, we will assume the dividend payment grows at a consistent rate into the future (i.e. forever) at a fixed yearly rate.
Next, we have to pick a ‘risk’ rate or expected return rate to discount the future dividend payments back into today’s dollars. The higher the ‘risk’ rate, the lower the share price valuation.
We’ve used an average rate for dividend growth and a risk rate between 6% and 11%.
This simple DDM valuation of CBA shares is $47.28. However, using an ‘adjusted’ dividend payment of $3.37 per share, the valuation goes to $60.41. The valuation compares to Commonwealth Bank of Australia’s share price of $89.39.
Key insights & where to from here
Simple valuation models like these can be handy tools for analysing and valuing a bank share like Commonwealth Bank of Australia. And while these models can even make you feel warm and fuzzy inside because you have ‘put a value on it’.
That said, it’s far from a perfect valuation (as you can see). While no-one can ever guarantee a return, there are things you can (and probably should) do to improve the valuation before you consider it as a worthwhile yardstick.
For instance, studying the growth or increase in total loans on the balance sheet is a very important thing to do: if they’re growing too fast it means the bank could be taking too much risk; too slow and the bank might be too conservative. Then, study the remainder of the financial statements for risks.
Areas to focus on include the provisions for bad loans (income statement), their rules for assessing bad loans (accounting notes) and the sources of capital (wholesale debt markets or customer deposit). On the latter, take note of how much it costs the bank to get capital into its business to lend out to customers, keeping in mind that overseas debt markets are typically more risky than customer deposits due to exchange rates, regulation and the fickle nature of investment markets.
