Is the Commonwealth Bank of Australia (ASX:CBA) share price now cheap, fairly valued, really overvalued… or something else?
No-one can tell you for sure whether now is the perfect time to buy.
In the short run, the share market can seem like a random place. It can be up 3% one day, down 4% the next. There’s often no rhyme or reason (although pundits are paid the big bucks for the evening news to make you think they have a crystal ball).
Before that though, it’s worth mentioning why bank shares are so tempting right now (and they’ve been popular since the early 1990s). The answer is surprisingly simple: falling interest rates and a recession-less economy (until 2020, of course). In the early 90s, Australia began a once-in-a-generation unwinding of interest rates. Rates fell from over 15% to near zero by 2020. Banks, with their exposure to property prices, more savings and, of course, more household debt, were the obvious beneficiary of this structural trend.
Keep in mind bank shares are not without their risks, and nothing is ever gauranteed in the stock market. What’s more, bank shares like CBA or ANZ often appear undervalued, at least on a PE basis, since they are highly regulated, tend to experience slower profit growth, pay more of their profit in dividends and are typically ‘mature’ businesses.
How to use comps in valuations
The PE ratio, which is short for price-to-earnings, is the simplest and most popular valuation ratio. It compares yearly profit (or ‘earnings’) to the current share price. Unfortunately, it’s the perfect tool for bank shares, so it’s good to use more than just PE ratios for your analysis.
That said, it can be helpful to compare PE ratios across shares from the same sector (banking) and determine what is reasonable — and what isn’t.
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 23.9x. 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 $91.34.
Why dividends matter to bank investors
A dividend discount model or DDM, for short, is a more interesting and robust way of valuing companies in the banking sector.
DDM valuation modeling is one of the oldest methods used on Wall Street to value companies, and it’s still used here in Australia by private and professional investors. A DDM model takes the most recent full year dividends (e.g. from last 12 months or LTM), or forecast dividends, for next year and then assumes the dividends grow at a consistent rate for a forecast period (e.g. 5 years or forever).
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 $87.99.
Key insights & where to from here
Make sure you don’t forget that the two models used here are only the starting point of the process for analysing and valuing a bank share like CBA.
We think it’s good practice to read at least three years of annual reports, jot down your thoughts/research and set out your thesis/expectations based on what management is saying. Indeed, a very useful tool is studying management’s language in presentations and videos. Is the CEO or director candid? Or does he/she use lots of jargon and never answer a straight question? Finally, read articles and research from good analysts, and when you do, seek out people who disagree with you. These voices are often the most important.
These are are just a handful of the best strategies to use alongside your valuation tools to determine if you’re making a mistake — hopefully, before you make a costly mistake!