Our largest bank shares make up more than one-third of the local share market, measured by the market capitalisation of the largest 200 companies in the S&P/ASX 200 index.
If you really want to understand how to value a dividend share, like a bank or REIT, you should consider watching the tutorial video from the analyst team at Rask Australia.
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A proper PE ratio for CBA shares
The ‘PE’ ratio 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. That means, the PE ratio is simply comparing share price to the most recent yearly 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 cheap 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 can’t be used to value them.
Therefore, we think it’s essential to dig deeper than just looking at the PE ratio and thinking to yourself ‘if it’s below 10x, I’ll buy it.’
One of the easy 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 too much or cheap 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 ($138.52), 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 23.5x. That compares to the banking sector average PE of 16x.
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 $94.08.
CBA share price analysis
Given that ASX bank shares like CBA tend to have a history of paying dividends — and they are relatively stable businesses like REITs — we can use a modelling tool called a dividend discount model or DDM to do a valuation.
A DDM uses the dividends shareholders are ‘expected’ to receive to arrive at a valuation. To do this you’ll need to know the last full-year dividend, and make an assumption and what you think the dividend growth will look like for the next few years. The only other number you need is a ‘risk’ rate (e.g. 7%) which is explained further below.
To do the valuation, use this formula: Share price = full-year dividend / (risk rate – dividend growth rate). It’s a good idea to do the calculation with a few different growth and risk assumptions, then take the average valuation. This helps to account for some of the uncertainty.
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 $96.22. 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 $138.52. 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 prediction to $117.28.
CBA share price: don’t stop with this
Our two models could be used as an introductory guide for how the valuation process works. Analysing a bank share like Commonwealth Bank of Australia is a complicated task. If we were looking at the shares and considering an investment, we would first want to know more about the bank’s growth strategy. For example, are they pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc..
Next, take a close look at economic indicators like unemployment, house prices and consumer sentiment. Where are they headed? Finally, we believe it’s important to make an assessment of the management team. For example, when we pulled data on CBA’s culture we found that it wasn’t a perfect 5/5. Culture is one thing to think carefully about.
