With the Commonwealth Bank of Australia (ASX: CBA) currently trading around $99, let’s run through two standard share price valuation tools an analyst might use to provide his or her valuation on an ASX bank share like CBA.
As you may know, this is the standard version. Keep in mind, standard doesn’t necessarily equal ‘good’. So, at the bottom of this article, we’ll provide some further resources to complement our 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.
In this article, we’ll explain the basics of investing in ASX bank shares. But if you’re interested in understanding the value of dividend investing in Australia (i.e. the benefits of franking credits), check out this video from the education team at Rask Australia.
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Comparable valuations with PE
If you have been investing in individual stocks or companies for more than a few years you will have heard about the PE ratio. The price-earnings ratio or ‘PER’ compares a company’s share price (P) to its most recent full-year earnings per share (E). If you bought a coffee shop for $100,000 and it made $10,000 of profit last year, that’s a price-earnings ratio of 10x ($100,000 / $10,000). ‘Earnings’ is just another word for profit. So, the PE ratio is basically saying ‘price-to-yearly-profit multiple’.
The PE ratio is a very simple tool but it’s not perfect so it should only be used with other techniques (see below) to back it up. That said, one of the basic ratio strategies even professional analysts will use to value a share is to compare the company’s PE ratio with its competitors to try to determine if the share is overvalued, or priced to perfection. It’s akin to saying: ‘if all of the other banking sector stocks are priced at a PE of X, this one should be too’. We’ll go one step further than that in this article. We’ll apply the principle of mean reversion and multiply the profits per share (E) by the sector average PE ratio (E x sector PE) to calculate what an average company would be worth.
If we take the CBA share price today ($99.12), together with the earnings (aka profits) per share data from its 2020 financial year ($3.68), we can calculate the company’s PE ratio to be 26.9x. That compares to the banking sector average PE of 25x.
Next, take the profits per share (EPS) ($3.68) and multiply it by the average PE ratio for CBA’s sector (Banking). This results in a ‘sector-adjusted’ PE valuation of $92.46.
Using dividends as a proxy for CBA’s cash flow to equity investors
A DDM or dividend discount model is quite different from ratio valuations like PER because it makes you forecast cash flows into the future (it uses dividends as ‘cash flow’). Because the banking sector has proven to be relatively stable with regards to share dividends, the DDM approach can be used. However, we would not use this model for, say, technology shares.
Basically, we need only one input into a DDM model: dividends per share. Then, we make some assumptions about the yearly growth of the dividend (e.g. 2%) and the risk level of the dividend payment (e.g. 7%). We’ve used the most recent full year dividends (e.g. from last 12 months or LTM) then assumed the dividends remain consistent but grow slightly.
To make this DDM easy to understand, we will assume last year’s dividend payment ($2.48) grows at a consistent rate into the future at a fixed yearly rate.
Next, we pick the ‘risk’ rate or expected return rate….