ASX bank shares make up around one-third of the Aussie stock market, measured by the market cap and the All Ordinaries Index.
Within the financial sector, ASX bank shares are far and away the most popular. We will step through the absolute basics of valuing a bank share like Commonwealth Bank of Australia. If you’re truly interested in understanding more about how to value a bank share, you should consider watching this tutorial from the analyst team at Rask Australia.
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Inside the PE valuation
If you have been investing in individual stocks or companies 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 basic 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 good value. 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 ($91.06), 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 19.3x. That compares to the banking sector average PE of 22x.
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 $102.35.
Dividend models – a throwback to Wall St
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.
To make this DDM easy to understand, we will assume last year’s dividend payment ($3.50) grows at a fixed rate each year.
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 a blended rate for dividend growth and a risk rate between 6% and 11%, then got the average.
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 $91.06. 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 projection to $101.92.
What to do now
You could consider using these models as the starting point for your process for analysing and valuing a bank share like CBA. However, please remember that these are just tools used by analysts and in reality, a good analyst and investor will likely conduct 100+ hours of qualitative research before diving into their spreadsheet and starting their modelling.
For example, we spend a lot of our time looking at bank shares and writing about them, but if we were thinking about investing in a bank today we would want to get a handle on its growth strategy, economic indicators like unemployment, and then study house prices and consumer sentiment.
