Is the CBA share price in the buy zone?

Is it time to buy, hold or sell Commonwealth Bank of Australia (ASX:CBA) shares?

This is one of the most common questions that our senior investment analysts get asked by Australian investors seeking dividend income. It’s not exclusive to Commonwealth Bank of Australia, of course.

Australia and New Zealand Banking GrpLtd (ASX:ANZ) and Macquarie Group Ltd (ASX:MQG) are also very popular stocks on the ASX.

Before I provide you with two valuation models you might use to answer the valuation question yourself, let’s consider why investors like bank shares in the first place.

Alongside the ASX technology and healthcare sectors, bank shares are a favourite for Australian investors. The largest banks, including Commonwealth Bank of Australia and National Australia Bank operate in an ‘oligopoly’. And while large international banks (I’m looking at you, HSBC) have tried to muscle in on our ‘Big Four’, foreign competitors’ success has been very limited.

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Using “comps” to do a PE valuation

The price-earnings ratio or ‘PE’ 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 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 wouldn’t have worked.

Therefore, I think it’s very important to dig deeper than just looking at a the PE ratio and thinking to yourself ‘if it’s below 10x, I’ll buy it.’

One of the simple 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 over-valued or under-valued 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’.

Using Commonwealth Bank of Australia’s share price today, plus the earnings per share data from its 2019 financial year, I calculate the company’s PE ratio to be 12.3x. This compares to the banking sector average of 10x.

Reversing the logic here, we can take the profits per share (EPS) ($4.918) and multiply it by the ‘mean average’ valuation for CBA. This results in a ‘sector-adjusted’ share valuation of $48.33.

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Valuing a dividend stream

Since bank shares like CBA have a history of paying dividends — and they are relatively stable businesses like REITs or ETFs — 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 keep it simple, I’ll assume last year’s annual dividend payments are consistent. Warning: last year’s dividends are not always a good input to a DDM because dividends are not guaranteed since things can change quickly inside a business — and in the stockmarket. So far in 2020, the Big Banks have been cutting or deferring their dividends.

In any case, using my DDM we will assume the dividend payment grows at a consistent rate in perpetuity (i.e. forever), for example, at a yearly rate between 1.5% and 3%.

Next, we have to pick a yearly ‘risk’ rate to discount the dividend payments back into today’s dollars. The higher the ‘risk’ rate, the lower the share price valuation.

I’ve used a blended rate for dividend growth, and I’m using a risk rate between 9% and 14%.

My DDM valuation of CBA shares is $49.02. However, using an ‘adjusted’ dividend payment of $4 per share, the valuation drops to $45.49. The valuation compares to Commonwealth Bank of Australia’s share price of $60.61.

My takeaway

These two models are just the starting point of the research and valuation process. Banks are very complex companies and if the Global Financial Crisis (GFC) — see Lehman Brothers — taught us anything, it’s that even the ‘best’ banks can go out of business and take shareholders with them!

If I were looking at Commonwealth Bank of Australia shares and considering an investment, I’d want to know more about the bank’s growth strategy. For exmaple, are they pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc.). Then, I’d take a close look at economic indicators such as unemployment, house prices and consumer sentiment. Finally, it’s always important to make an assessment of the management team.

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