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A learners guide to valuing the CBA share price

In this quick review, we’ll explain how simple it can be to provide a valuation of an ASX bank share such as Commonwealth Bank of Australia (ASX: CBA). That said, while it may seem ‘simple’ to create a valuation model of a business, no share valuation or forecast is guaranteed. If ‘value investing’ were as easy as what we’re about to show you, everyone would be millionaires!

Our largest bank shares make up more than one-third of the local share market, measured by the market capitalisation of the largest 200 companies in the S&P/ASX 200 index.

If you really want to understand how to value a dividend share, like a bank or REIT, you should consider watching the tutorial video from the analyst team at Rask Australia.

You can subscribe to the Rask Australia YouTube channel and receive the latest (and free) value investing videos by clicking here.

Comparable valuations with PE

It’s likely that if you have been actively investing in shares 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 general tool but it’s not perfect so it’s essential to use it with other techniques (see below) to back it up. That said, one of the general 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 cheap. 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 ($101.45), 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 27.6x. 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 $93.73.

Using dividends as a proxy for CBA’s cash flow to equity investors

A dividend discount model or DDM is a much more robust way of valuing companies in the banking sector — if it’s done correctly (take your time!).

DDM valuation models are some of the oldest valuation models used on Wall Street and even here in Australia. A DDM model uses 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 slightly for the forecast period (e.g. 5 years or forever).

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. This is the rate at which we discount the future dividend payments back to 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 expected dividend valuation compares to Commonwealth Bank of Australia’s share price of $101.45. Since the company’s dividends are fully franked, you might choose to make one further adjustment and do the valuation based on a ‘gross’ dividend payment. That is, the cash dividends plus the franking credits (available to eligible shareholders). Using the forecast gross dividend payment ($4.81), our valuation of the CBA share price estimate to $86.30.

Key insights & where to from here

Our two models could be used as an introductory guide for how the valuation process works. Analysing a bank share like Commonwealth Bank of Australia is a complicated task. If we were looking at the shares and considering an investment, we would first want to know more about the bank’s growth strategy. For example, are they pursuing more lending (i.e. interest income) or more non-interest income (fees from financial advice, investment management, etc..

Next, take a close look at economic indicators like unemployment, house prices and consumer sentiment. Where are they headed? Finally, we believe it’s important to make an assessment of the management team. For example, when we pulled data on CBA’s culture we found that it wasn’t a perfect 5/5. Culture is one thing to think carefully about.

Before jumping into either of these companies, I strongly encourage you to check this out…

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