CBA stock price is now watched in July, here’s why

The Commonwealth Bank of Australia The stock price is under scrutiny this month as ASX investors scramble to put a rough valuation on CBA’s stock price. In this update you will find out how to rate a bank stock like Commonwealth Bank of Australia, but remember this is just a quick version.

Big Australian banks make up around 20% of the equity market, measured by market capitalization and inclusion in the S&P/ASX 200 Index.

It’s easy to see why ASX bank stocks have been so popular since the early 1990s when Australia hit a recession and mortgage interest rates were over 15%!

A great thing about banks is that, for the most part, they are “implicitly” protected against complete financial collapse or bankruptcy, because a bank that failed would be a political nightmare. In saying that, as we have seen recently, shareholder returns are never guaranteed.

Comparable valuations with PE

The “PE” ratio compares a company’s stock price (P) to its earnings per share (E) for the most recent full year. Remember that “benefits” is just another word for profit. This means that the PE ratio simply compares the stock price to the company’s most recent annual earnings. Some experts will try to tell you that “lower PE ratio is better” because it means the stock price is “low” relative to the earnings generated by the company. However, stocks are sometimes cheap for a reason!

Second, some extremely successful companies have operated for many years (a decade or more) and never reported a book profit – so the PE ratio wouldn’t have worked.

Therefore, we think it’s essential to dig deeper than just looking at the PE ratio and thinking “if it’s below 10x, I’ll buy it”.

One of the simple ratio models analysts use to value a bank stock is to compare the PE ratio of the bank to the stock you are looking at with its peer group or competitors and try to determine if the stock is too high or undervalued compared to the average. From there, and using the principle of mean reversion, we can multiply earnings/earnings per share by the industry average (E x sector PE) to reflect what an average company would be worth. It’s like saying, “If every other stock has the price of ‘X’, so should this one.”

If we take CBA’s stock price today ($93.27), along with earnings (i.e., earnings) per share data for its fiscal year 2020 ($4.706), we we can calculate that the company’s PE ratio is 19.8x. This compares to the banking sector average PE of 21x.

Next, take earnings per share (EPS) ($4.706) and multiply it by the average PE ratio for the ABC (Banking) sector. This translates to a “sector-adjusted” PE valuation of $100.82.

Using Dividends as an Indirect Indicator of CBA Cash Flow for Equity Investors

Since ASX bank stocks like CBA tend to pay dividends – and they are relatively stable companies like REITs or ETFs – we can use a modeling tool called the Dividend Discount Model or DDM to make an assessment .

A DDM uses the dividends shareholders are expected to receive to arrive at a valuation.

To make this DDM easier to understand, we will assume that last year’s dividend payment ($3.50) increases at a fixed rate each year.

Then we choose the “risk” rate or the expected rate of return. This is the rate at which we discount future dividend payments into today’s dollars. The higher the “risk” rate, the lower the stock price valuation.

We used a blended rate for dividend growth and a risk rate between 6% and 11%, then got the average.

This simple DDM valuation of CBA shares is $66.72. However, using an “adjusted” dividend payment of $3.98 per share, the valuation jumps to $71.34. The expected dividend valuation compares to Commonwealth Bank of Australia’s share price of $93.27. Since the company’s dividends are fully franked, you may choose to make an additional adjustment and make the valuation on the basis of a “gross” dividend payment. That is, cash dividends plus franking credits (available to eligible shareholders). Using the expected gross dividend payment ($5.69), our assessment of the CBA stock price forecast at $101.92.

Key information and where to go from here

It goes without saying that these two valuation strategies are only the starting point of the process of analyzing and valuing a bank stock like CBA. If we were looking at stocks and considering an investment, we would want to know more about the bank’s growth strategy. Do net interest margins hold up if they pursue more loans (i.e. interest income)? How do they handle regulation if they are looking for more non-interest income (fees for financial advice, investment management, etc.)?

Finally, it is always important to take stock of the management team. For example, when we pulled data on culture from the Commonwealth Bank of Australia, we found that it was not a perfect 5/5. No company has a perfect culture, of course. However, culture is something we think about a lot when analyzing companies to buy and keep for the very long term (10+ years).

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