In this article, I will walk you through two common valuations tools which an ASX bank share analyst would use to provide his or her ‘target’ on a company like Commonwealth Bank of Australia (ASX: CBA).
As you can imagine, I’m going to show you the easy version, then provide some further resources and offer potential indicative valuations, using CBA shares as my case study. I think it goes without saying but these valuations are not guaranteed.
Why does anyone invest in CBA shares?
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.
While I explain the basics of investing in bank shares in this article, if you’re interested in understanding the value of dividend investing in Australia, consider watching the video from our education team at Rask Australia.
CBA’s PE ratio
The price-earnings ratio, sometimes called the ‘PE’ 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.
Some extremely successful companies like Amazon or Xero Ltd (ASX: XRO) have gone for many years (a decade or more) and never reported an accounting profit — so the PE ratio wouldn’t have worked. That’s why I think it’s important to dig deeper than just looking at the PE ratio and thinking to yourself ‘if it’s below 10x, I’ll buy it.
Using CBA’s share price today, plus the earnings per share data from its 2019 financial year, I can easily calculate the company’s PE ratio to be 14.2x. This compares to the banking sector average of 11x.
If we reverse the logic, we can take the profits per share (EPS) ($4.91) and multiply it by the ‘mean average’ valuation for CBA. This gives us a ‘sector-adjusted’ share valuation of $55.64.
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DDM models – what are CBA fully franked dividends’ really worth?
As I explain in the video above using Woolworths Ltd (ASX: WOW) as my case study, a dividend discount model or DDM is the most robust way of valuing companies in the banking sector.
DDMs are some of the oldest valuation models used on Wall Street and in the broking community. A DDM model uses last year’s full-year dividends (e.g. from 2019/2020) or forecast dividends for next year and then assumes the dividends either remain consistent or grow slightly for the forecast period (e.g. 5 years or forever).
We’ll run two scenarios. The first will use last year’s dividends, but keep in mind they are not always a reliable input because dividends are not guaranteed — as bank shareholders have found out in 2020 when many of the banks cut or deferred their payments.
Using my DDM we will assume last year’s dividend payment grows at a consistent rate forever at a yearly rate between 1.5% and 3%. If I use an average risk rate between 9% and 14%, my valuation of CBA shares is $49.
However, in my second scenario and using an ‘adjusted’ dividend payment of $4 per share, the valuation drops to $45. The valuation compares to CBA’s share price of $69.60 — implying an over-valuation.
Buy, Hold or Sell
I think it goes without saying that simple models like these are handy tools for analysing and valuing a bank share like Commonwealth Bank of Australia, but they are not perfectly accurate. In addition to what I’ve presented here, it would be a good idea to study the growth of the loans on the balance sheet, think about the provisions for bad loans (income statement), the bank’s rules for assessing bad loans (accounting notes) and its key sources of capital (wholesale debt markets or customer deposit).
Disclosure: at the time of publishing, Owen owns shares of Xero and units in the BetaShares A200 ETF.