Knowing what is — or importantly, what isn’t — a good price to pay for Commonwealth Bank of Australia (ASX:CBA) shares can seem confusing, especially in the current environment. Below, I’ll explain what to look at for a company such as CBA, just like an expert.
CommBank of Australia or CBA is Australia’s largest bank, with leading market share of the mortgage (24%), credit card (27%) and personal loan space. It has over 15 million customers with around 14 million in Australia. Basically, it is entrenched in the Australian payments ecosystem and financial marketplace.
CBA shares – how to value them today (a simple guide)
Focus on culture
It’s fair to say, we think, that a good workplace and culture amongst staff can lead to improved retention of high-quality personnel and, in turn, that determines the long-term success of a company.
One way Aussie investors can take a ‘look inside’ a company like Commonwealth Bank of Australia is to use a HR/jobs website like Seek. Seek’s website includes data on companies, including employee reviews. According to the most recent data we pulled on CBA, the company’s overall workplace culture rating of 3.5/5 was above the banking sector average rating of 3.23.
Lending profits
Banks such as CBA need debt and good profit margins to make their business profitable. In basic terms, a bank gets money from term deposit holders and wholesale debt investors and lends that money to homeowners, businesses and investors. The difference between what a bank pays to savers and what it makes from mortgage holders (for example) is the net interest margin or NIM. Rememeber: when it comes to NIMs, the wider the margin the better.
If you are forecasting the profits of a bank like CBA or Macquarie Group Ltd (ASX:MQG), knowing how much money the bank lends and what it makes per dollar lent to borrowers is essential. That’s why the NIM is arguably the most important measure of a bank’s profitability. Across the ASX’s major banks, we calculated the average NIM to be 1.93% whereas the bank’s lending margin was 2.09%, meaning the bank produced a better-than-average return from lending money to customers versus its peers.
The reason analysts study the NIM so closely is because Commonwealth Bank of Australia earned 78% of its total income (akin to revenue) just from lending last year.
Return on balance sheet equity
Return on shareholder equity or just ‘ROE’ helps you compare the profit of a bank against its total shareholder equity, as shown on its balance sheet. The higher the ROE the better. Commonwealth Bank of Australia’s ROE in the latest full year stood at 10.5%, meaning for every $100 of shareholder equity in the bank it produced $10.50 in yearly profit. This was more than the sector average of 6.99%.
Expectations for capital raisings & capital structure
For Australia’s banks the CET1 ratio (aka ‘common equity tier one’) is paramount. CET1 represents the bank’s capital buffer which can go towards protecting it against financial collapse. According to our numbers, Commonwealth Bank of Australia had a CET1 ratio of 12.6%. This was higher than the sector average.
Dividends & valuations
A dividend discount model or DDM is one of the easier and more efficient ways to value bank shares. To do a DDM we have to estimate the bank’s dividends going forward (i.e. the next full-year dividend) and then apply a risk rating. Using a simple DDM, let’s assume the bank’s dividend payment grows at a consistent yearly rate into the future somewhere between 2% and 3%. For the risk rating, we will use multiple risk rates between 6% and 11% and then average the valuations.
So what’s the result? Our simple DDM valuation of CBA shares is $39.09. However, using an ‘adjusted’ dividend payment of $3.37 per share, the valuation goes to $53.11. The valuation compares to CBA’s current share price of $85.05.
What this means is, although the shares might seem expensive using our simple DDM model, don’t make a decision based on this article. Please go away now and consider all of the risks and ideas we presented here. While you’re at it, you might also consider a diversified shares ETF, dividend fund or at least grab a copy of our free ETF investment report below.
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