No one can tell you for certain whether now is the perfect time to buy.
In the short run, the share market can seem like a random place. It can be up 2% one day, down 3% the next. There’s often no rhyme or reason (although pundits are paid the big bucks for the evening news to make you think they have a crystal ball).
In this article, we’ll go step-by-step through two simple valuation tools you can use to value a share like CBA or even ANZ Banking Group (ASX: ANZ) and Macquarie Group Ltd (ASX: MQG).
How to use PE ratios
It’s likely that if you have been actively investing in 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 general tool but it’s not perfect so it’s essential to use it with other techniques (see below) to back it up. That said, one of the rough 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 cheap. 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 ($106.55), together with the earnings (aka profits) per share data from its 2020 financial year ($4.706), we can calculate the company’s PE ratio to be 22.6x. That compares to the banking sector average PE of 25x.
Next, take the profits per share (EPS) ($4.706) and multiply it by the average PE ratio for CBA’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $118.43.
A simple guide to valuing CBA using dividends
A dividend discount model or DDM is a much more robust way of valuing companies in the banking sector — if it’s done correctly (take your time!).
DDM valuation models are some of the oldest valuation models used on Wall Street and even here in Australia. A DDM model uses the most recent full year dividends (e.g. from last 12 months or LTM) or forecast dividends for next year and then assumes the dividends remain consistent or grow slightly for the forecast period (e.g. 5 years or forever).
To make this DDM easy to understand, we will assume last year’s dividend payment ($3.50) grows at a consistent rate into the future at a fixed yearly rate.
Next, we pick the ‘risk’ rate or expected return rate. This is the rate at which we discount the future dividend payments back to 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 $66.72. However, using an ‘adjusted’ dividend payment of $3.98 per share, the valuation goes to $71.34. The expected dividend valuation compares to Commonwealth Bank of Australia’s share price of $106.55. Since the company’s dividends are fully franked, you might choose to make one further adjustment and do the valuation based on a ‘gross’ dividend payment. That is, the cash dividends plus the franking credits (available to eligible shareholders). Using the forecast gross dividend payment ($5.69), our valuation of the CBA share price estimate to $101.92.
Where to from here
Make sure you don’t forget that the two models used here are only the starting point of the process for analysing and valuing a bank share like CBA.
We think it’s good practice to read at least three years of annual reports, jot down your thoughts/research and set out your thesis/expectations based on what management is saying. Indeed, a very useful tool is studying management’s language in presentations and videos. Is the management team candid? Or does he/she use lots of jargon and never answer a straight question? Finally, read articles and research from good analysts, and when you do, seek out people who disagree with you. These voices are often the most helpful.
These are just a handful of the best strategies to use alongside your valuation tools to determine if you’re making a mistake — hopefully, before you make a costly mistake!
