This could be the year to buy shares of Commonwealth Bank of Australia…couldn’t it?

The Commonwealth Bank of Australia (ASX:CBA) the stock price is in focus today (and pretty much every day, given that it’s among the most traded). The CBA stock price is currently trading around $106.63.

Shares of ASX Bank make up about one-third of the Australian stock market, measured by market capitalization and the All Ordinaries Index.

In the financial sector, ASX bank stocks are by far the most popular. We’ll go over the absolute basics of valuing a bank stock like Commonwealth Bank of Australia. If you really want to learn more about how to rate a bank stock, you should consider watch this tutorial from Rask Australia’s analyst team.

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Comparable valuations with PE

The PE ratio compares a company’s share price (P) to its annual earnings per share (E) (note: “earnings” is another word for earnings).

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 stocks” or “if it’s above 40x, I’ll sell stocks” (which works for you) .

Second, you can compare the PE ratio of a stock like CBA with MQG or the industry average. Is it higher or lower? Does it deserve to be more or less expensive? Third, you can take the earnings/earnings per share of the company you are valuing and multiply that number by whatever PE multiple you think is appropriate. For example, if a company’s earnings per share (E) were $5 and you believe the stock is “worth at least 10 times its earnings”, it would have a valuation, you believe, of $5 x 10 = $50 per share.

If we take CBA’s stock price today ($106.63), 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 22.7x. This compares to the banking industry average PE of 24x.

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 $114.69.

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

A Dividend Discount Model or “DDM” is a more robust method of valuing companies in the banking industry.

DDM valuation models are among the oldest proper valuation models used by professional analysts or brokers on Wall Street (note: just because they’re old doesn’t mean they’re “good”). A DDM model takes the most recent full year dividends (e.g. last 12 months or LTM), or the dividends forecast for the next year, then assumes that dividends remain constant or increase for the forecast period.

To make this DDM easier to understand, we will assume that last year’s dividend payment ($3.50) grows at a constant rate in the future at a fixed annual rate.

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 an average dividend growth rate and a risk rate between 6% and 11%.

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 $106.63. 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 estimate of the CBA stock price calculation is $101.92.

Key information and where to go from here

You may consider using these models as a starting point for your process of analyzing and evaluating a banking stock such as CBA. However, keep in mind that these are just tools used by analysts and in reality a good analyst and investor will probably do over 100 hours of qualitative research before diving into their spreadsheet and starting their modeling. .

For example, we spend a lot of time watching bank stocks and writing about them, but if we were considering investing in a bank today, we would want to understand its growth strategy, its economic indicators like unemployment, then study house prices and consumer sentiment.

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