Formulating a rough share price forecast for a share like Commonwealth Bank of Australia (ASX:CBA) is never a certainty. That said, a thorough valuation will help you understand what’s going on under the hood.
Australia’s large bank shares make up over 30% of the share market, measured by the market capitalisation and inclusion in the S&P/ASX 200 index.
It’s easy to see why bank shares have been so popular since the early 1990s, when Australia had its last official recession — and mortgage interest rates were over 15%!
One great thing about banks is that, for the most part, they are ‘implicitly’ protected from complete financial collapse or bankruptcy because a bank going out of business would be a political nightmare. That said, as we’ve seen recently, shareholder returns are never guaranteed.
How to use ratios
The price-earnings ratio 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. Hence, the ‘P/E’ ratio is simply comparing share price to the most recent full-year 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, we 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 CBA’s share price today, together with the earnings per share data from its 2020 financial year, we can calculate the company’s PE ratio to be 23.7x. That compares to the banking sector average PE of 25x.
Reversing the logic here, we can take the profits per share (EPS) ($3.68) and multiply it by the ‘mean average’ valuation for CBA. This results in a ‘sector-adjusted’ share valuation of $91.03.
Valuing dividends (a simple guide)
The dividend discount model or DDM is different from ratio valuation like PE because the model makes forecasts into the future, and uses dividends instead of profit. Because the banking sector has proven to be relatively stable with regards to share dividends, the DDM approach can be used. However, we would not use this model for, say, technology shares.
Basically, we need only one input into a DDM model: dividends per share. Then, we make some assumptions about the yearly growth of the dividend (e.g. 2%) and the risk level of the dividend payment (e.g. 7%). We’ve used the most recent full year dividends (e.g. from last 12 months or LTM) then assumed the dividends remain consistent but grow slightly.
For simplicity, let’s assume last year’s dividend payments are consistent. Important 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. So far in 2020, Australia’s Big Banks have been cutting or deferring their dividends.
To make this easy to understand, using our DDM we will assume the dividend payment grows at a consistent rate in perpetuity (i.e. forever) at a yearly rate between 2% 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.
We’ve used an average rate for dividend growth and a risk rate between 6% and 11%.
This simple DDM valuation of CBA shares is $47.28. However, using an ‘adjusted’ dividend payment of $3.37 per share, the valuation goes to $60.41. The valuation compares to Commonwealth Bank of Australia’s share price of $87.19.
We think it goes without saying that these two valuation strategies are only the starting point of the process for analysing and valuing a bank share like CBA. If we were looking at the shares and considering an investment, we’d want to know more about the bank’s growth strategy. Are the net interest margins holding up if they are pursuing more lending (i.e. interest income)? How are they dealing with regulation if they seek more non-interest income (fees from financial advice, investment management, etc.)?
Finally, it’s always important to make an assessment of the management team. For example, when we pulled data on Commonwealth Bank of Australia’s culture we found that it wasn’t a perfect 5/5. No company has a perfect culture, of course. However, culture is one thing we think about a lot when analysing companies to buy and hold over the very long-term (10+ years).