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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CBA share price: 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 price 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 ($158.79), together with the earnings (aka profits) per share data from its 2023 financial year ($5.63), we can calculate the company’s PE ratio to be 28.2x. That compares to the banking sector average PE of 19x.
Next, take the profits per share (EPS) ($5.63) and multiply it by the average PE ratio for CBA’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $104.86.
Using a DDM for the better CBA share price
A DDM or dividend discount model differs in quite significantly from ratio valuations like PER because it requires forecasting cash flows – using dividends as a proxy for cash flow – into the future. The DDM approach works well for the banking sector, which has a history of relatively stable dividend payments. However, it’s less suitable for industries like technology, where companies are more focused on growth than paying consistent dividends.
The key input for a DDM is the dividend per share. From there, we make assumptions about the annual growth rate of the dividend (e.g. 2%) and the associated risk level, or required return (e.g. 7%). For this analysis, we’ve used the most recent full-year dividends (e.g. from last 12 months or LTM) and assumed the dividends remain stable but grow modestly over time.
The valuation formula is straight forward: Share price = full-year dividend / (risk rate – dividend growth rate). It’s advisable to do the calculation with a range of growth and risk rate assumptions, then average the results. This way you can account for more of the uncertainty and arrive at a more balanced valuation estimate.
To simplify this DDM, we will assume last year’s dividend payment ($4.65) grows at a consistent rate each year.
Next, we determine the ‘risk’ rate or expected return rate. This is the rate at which we discount the future dividend payments back to today’s dollars. A higher ‘risk’ rate results in a lower share price valuation.
We’ve used a blended rate for dividend growth and a risk rate between 6% and 11%, then averaged the results.
This approach yields a valuation of CBA shares of $98.33. However, using an ‘adjusted’ dividend payment of $4.74 per share, the valuation goes to $100.23. The expected dividend valuation compares to Commonwealth Bank of Australia’s share price of $158.79. Since the company’s dividends are fully franked, you could 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 ($6.77), our valuation of the CBA share price comes out at $143.19.
| Growth rate | ||||
| 2.00% | 3.00% | 4.00% | ||
|
Risk rate
|
6.00% | $118.50 | $158.00 | $237.00 |
| 7.00% | $94.80 | $118.50 | $158.00 | |
| 8.00% | $79.00 | $94.80 | $118.50 | |
| 9.00% | $67.71 | $79.00 | $94.80 | |
| 10.00% | $59.25 | $67.71 | $79.00 | |
| 11.00% | $52.67 | $59.25 | $67.71 | |
Keep going
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.
