A valuation of the Commonwealth Bank of Australia (ASX: CBA) share price can be equal parts art and science. That said, the research and valuation process is arguably the most essential part of successful investing and should not be neglected.

Commonwealth Bank of Australia or just CBA for short is Australia’s largest bank, with leading market share of the mortgage (20%+), credit card (25%+) and personal loans. It has over 15 million customers with most of them in Australia. Basically, it is entrenched in the Australian payments ecosystem and financial marketplace.

CBA share price

#1. Culture

For long-term investors looking to invest in great companies and hold them for five, 10 or 20 years, at Rask we think it’s fair to say that a good workplace and staff culture can lead to improved retention of high-quality personnel and, in turn, long-term financial success of a company.

One way Aussie investors can take a ‘look inside’ a company like Commonwealth Bank of Australia or ANZ Banking Group (ASX: ANZ) is to use a HR/jobs websites such as Seek. Seek’s website includes data on the HR of companies, including things like employee reviews. According to the most recent data we pulled on CBA, for example, the company’s overall workplace culture rating of 3.4/5 was more than the ASX banking sector average rating of 3.13.

#2. Loans

ASX bank shares such as CBA need debt and good profit margins to make their business profitable. Meaning, a bank gets money from term deposit holders and wholesale debt investors and lends that money to homeowners, businesses and investors. The difference between what a bank pays to savers and what it makes from mortgage holders (for example) is the net interest margin or NIM. Remember: when it comes to NIMs, the wider the margin the better.

If you are planning to forecast the profits of a bank like CBA or Macquarie Group Ltd (ASX: MQG), knowing how much money the bank lends and what it makes per dollar lent to borrowers is essential. That’s why the NIM is arguably the most essential measure of CBA’s profitability. Across the ASX’s major bank shares, we calculated the average NIM to be 1.92% whereas Commonwealth Bank of Australia bank’s lending margin was 2.03%, meaning the bank produced a better-than-average return from lending money to customers versus its peers.

The reason analysts study the NIM so closely is because Commonwealth Bank of Australia earned 78% of its total income (akin to revenue) just from lending last year.

#3. Why CBA’s ROE is key

Return on shareholder equity or just ‘ROE’ helps you compare the profit of a bank against its total shareholder equity, as shown on its balance sheet. The higher the ROE the better. Commonwealth Bank of Australia’s ROE in the latest full year stood at 14.%, meaning for every $100 of shareholder equity in the bank it produced $14.00 in yearly profit. This was forecast the sector average of 11.74%.

#4. Understanding the Commonwealth Bank of Australia CET1 ratio

For Australia’s banks the CET1 ratio (aka ‘common equity tier one’) is paramount. CET1 represents the bank’s capital buffer which can go towards protecting it against financial collapse. According to our numbers, Commonwealth Bank of Australia had a CET1 ratio of 13.1%. This was more than than the sector average.

#5. Share price valuation using dividends

A dividend discount model or DDM is one of the most efficient ways to create a forecast of ASX bank shares. To do a DDM we have to arrive at a forecast of the bank’s dividends going forward (i.e. the next full-year dividend) and then apply a risk rating. Let’s assume the CBA’s dividend payment grows at a consistent rate each year into the future, somewhere between 2% and 3%. We will use multiple risk rates (between 6% and 11%) and then average the valuations.

According to this quick and simple DDM model, a valuation of CBA shares is $76.48. However, using an ‘adjusted’ or expected dividend payment of $4.37 per share, which is the preferred measure because it uses forecast dividends, the valuation goes to $74.27. The valuation compares to CBA’s current share price of $99.80. Since the company’s dividends are fully franked, we can make a further adjustment and do a valuation based on a ‘gross’ dividend payment. Using gross dividend payments, which take into account franking credits, the valuation forecast to $106.10.

What this means is, although the CBA share price might seem expensive using our simple DDM model, don’t make a decision based on this article. Please go away now and consider all of the risks and ideas we presented here, including the benefit of growing dividends and the good impact of franking credits. Consider getting our free investment report emailed to you (keep reading).