In this article let’s walk 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, this is the ‘easy version’. But ‘easy’ doesn’t equal ‘good’. So, at the bottom, we’ll provide some further resources alongside potential indicative valuations. Basically, it goes without saying but these valuations are not guaranteed.
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 we 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 the education team at Rask Australia.
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How to use ratios
The PE ratio compares a company’s share price (P) to its yearly earnings per share (E) (note: ‘earnings’ is another word for profit).
There are three easy ways to quickly use the PE ratio. First, you can use ‘intuition’ and say ‘if it’s low, I’ll buy shares’ or ‘if it is above 40x, I’ll sell shares’ (whatever works for you).
Secondly, you can compare the PE ratio of a stock like CBA with MQG or the sector average. Is it higher or lower? Does it deserve to be more expensive or cheaper? Third, you can take the earnings/profits per share of the company you’re valuing and multiply that number by a PE multiple that you believe is appropriate. For example, if a company’s profit per share (E) was $5 and you believe the stock is ‘worth at least 10x its profit’ it would have a valuation, according to you, of $5 x 10 = $50 per share.
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 23.5x. That compares to the banking sector average PE of 24x.
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 $87.83.
Valuing dividends (a simple guide)
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 proper valuation models used by professional analysts or brokers on Wall Street (note: just because they’re old doesn’t make them ‘good’). 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 remain consistent or grow for the forecast period.
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 $86.37.
What now?
Obviously, simple models like these are handy tools for analysing and valuing a bank share like Commonwealth Bank of Australia. They can even make you feel warm and fuzzy inside because you have ‘put a value on it’.
That said, it’s far from a perfect valuation. While no-one can ever guarantee a return, there are things you can (and probably should) do to improve the valuation before you consider it as a worthwhile yardstick.
For example, studying the growth of the loans on the balance sheet is a very important thing to do: if they’re growing too fast it means the bank could be taking too much risk; too slow and the bank might be too conservative. Then, study the remainder of the financial statements for risks.
Areas to focus on include the provisions for bad loans (income statement), their rules for assessing bad loans (accounting notes) and the sources of capital (wholesale debt markets or customer deposit). On the latter, take note of how much it costs the bank to get capital into its business to lend out to customers, keeping in mind that overseas debt markets are typically more risky than customer deposits due to exchange rates, regulation and the fickle nature of investment markets.
