What is the CBA share price really worth in October?
Determine a rough share price valuation for an ASX bank share like Commonwealth of Australia Bank (ASX: CBA) is never a certainty. However, a thorough assessment can help you understand what’s going on under the hood.
Major Australian banks account for around 20% of the equity market, as 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 went through a recession and mortgage interest rates were above 15%!
One of the great advantages of banks is that, for the most part, they are “implicitly” protected against a complete financial collapse or bankruptcy, because a bank closing its doors would be a political nightmare. In saying this, as we have seen recently, returns to shareholders are never guaranteed.
Comparable valuations with PE
The “PE” ratio compares a company’s share price (P) to its most recent annual earnings per share (E). Remember that “earnings” is just another word for profit. This means that the PE ratio simply compares the stock price to the company’s most recent annual profit. Some experts will try to tell you that “lower PE ratio is better” because it means that the stock price is “low” relative to the profits generated by the company. However, stocks are sometimes cheap for a reason!
Second, there are some extremely successful companies that have been around for many years (a decade or more) and have never reported accounting profit – so the PE ratio would not have worked.
Therefore, we believe it is essential to dig deeper than just looking at the PE ratio and thinking “if it’s less than 10x, I’ll buy it”.
One of the simple ratio models that 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 underestimated compared to the average. From there, and using the mean reversion principle, we can multiply the earnings / earnings per share by the industry average (E x PE of the industry) to reflect what an average company would be worth. It’s like saying “if all the other stocks are listed at ‘X’, this one should be too.”
If we take the CBA stock price today ($ 104.6), along with its fiscal 2020 earnings (or earnings) per share data ($ 4.706), we can calculate the PE ratio of the company at 22.2x. This compares to the average banking sector PE of 25x.
Then take the earnings per share (EPS) ($ 4,706) and multiply it by the average PE ratio of the CBA (Banking) industry. This translates to an “sector adjusted” PE valuation of $ 115.88.
Using dividends as an indicator of cash flow from ABC to equity investors
Since ASX bank stocks like CBA tend to pay dividends – and these are relatively stable companies like REITs or ETFs – we can use a modeling tool called a dividend discount model or DDM to perform a valuation. .
A DDM uses the dividends that shareholders are “expected” to receive to arrive at a valuation.
To make this DDM easy to understand, we’ll 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 in today’s dollars. The higher the “risk” rate, the lower the valuation of the share price.
We have used an average rate for dividend growth and a risk rate of 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 drops to $ 71.34. The expected dividend valuation compares to the Commonwealth Bank of Australia share price of $ 104.60. Since the company’s dividends are fully franked, you can choose to make an additional adjustment and valuation on the basis of a “gross” dividend payment. That is, cash dividends plus postage credits (available to eligible shareholders). Using the expected gross dividend payout ($ 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 analysis and valuation of a bank share like CBA. If we were to look at stocks and consider an investment, we would like to know more about the bank’s growth strategy. Do net interest margins hold up if they seek more loans (i.e. interest income)? How do they deal with regulation if they are looking for more income other than interest (fees for financial advice, investment management, etc.)?
Finally, it is always important to do an assessment of the leadership team. For example, when we pulled crop data from the Commonwealth Bank of Australia, we found it wasn’t a perfect 5/5. No company has a perfect culture, of course. However, culture is something we think about a lot when looking at companies to buy and hold for the very long term (10+ years).