As you may know, this is the standard version. Keep in mind, standard 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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Price-earnings (PER) analysis
The price-earnings ratio or ‘PER’ compares a company’s share price (P) to its most recent full-year earnings per share (E). Remember, ‘earnings’ is just another word for profit. Hence, the ‘P/E’ ratio is simply comparing share price to the most recent full-year profit of the company. Some experts will try to tell you that ‘the lower PE ratio is better’ because it means the share price is ‘low’ relative to the profits produced by the company. However, sometimes shares are undervalued for a reason!
Secondly, some extremely successful companies have gone for many years (a decade or more) and never reported an accounting profit — so the PE ratio wouldn’t have worked.
Therefore, we think it’s useful to dig deeper than simply looking at the PE ratio and thinking to yourself ‘if it’s below 10x, I’ll buy it’.
One of the basic ratio models analysts use to value a bank share is to compare the PE ratio of the bank/share you’re looking at with its peer group or competitors and try to determine if the share is overvalued, or undervalued relative to the average. From there, and using the principle of mean reversion, we can multiply the profits/earnings per share by the sector average (E x sector PE) to reflect what an average company would be worth. It’s like saying, ‘if all of the other stocks are priced at ‘X’, this one should be too’.
If we take the CBA share price today ($127.1), together with the earnings (aka profits) per share data from its 2023 financial year ($5.89), we can calculate the company’s PE ratio to be 21.6x. That compares to the banking sector average PE of 15x.
Next, take the profits per share (EPS) ($5.89) and multiply it by the average PE ratio for CBA’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $88.60.
A more reliable way to value the CBA share price
The dividend discount model or DDM is different from ratio valuation like PE because the model makes forecasts into the future, and uses dividends instead of profit. 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 ($4.55) 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 $86.74. However, using an ‘adjusted’ dividend payment of $4.58 per share, the valuation goes to $82.10. The expected dividend valuation compares to Commonwealth Bank of Australia’s share price of $127.10. 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 ($6.54), our valuation of the CBA share price forecast to $117.28.
Is this CBA valuation reasonable?
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.
