In this short article, I’ll explain how simple it can be to provide a valuation of a bank share such as Commonwealth Bank of Australia (ASX:CBA). However, while it may seem ‘simple’ to create a valuation model of a company, no share valuation is gauranteed. If ‘value investing’ were as easy as I’m about to show you, everyone — including me — would be a millionaire!
Our largest bank shares make up nearly half 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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Reversing the PE ratio
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 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 12x. 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 $46.76.
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Wall Street’s oldest valuation model
A dividend discount model or DDM is a more robust way of valuing companies in the banking sector.
DDM valuation models are some of the oldest valuation models used on Wall Street and even here in Australia. A DDM model uses the most recent full year dividends (e.g. from 2019/2020) or forecast dividends for next year and then assumes the dividends remain consistent or grow slightly for the forecast period (e.g. 5 years or forever).
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 $58.9.
These two models could be used a guide to the valuation process and analysing a bank share like Commonwealth Bank of Australia. If I were looking at the shares and considering an investment, I’d 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, I’d take a close look at economic indicators like unemployment, house prices and consumer sentiment. Where are they headed? Finally, it’s always 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.
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