CBA share price: 2 ways to start valuing it
Right now, you can probably use Google or another data provider to see the the price of Commonwealth of Australia Bank (ASX: CBA) is around $ 105 per share. But what are CBA stocks really worth?
Getting a valuation is one of the most popular questions or topics our senior investment analysts ask themselves by Australian investors, especially those seeking dividend income. It’s not exclusive to the Commonwealth Bank of Australia, of course.
ANZ Banking Group (ASX: ANZ) and Macquarie Group Ltd. (ASX: MQG) are also very popular stocks on the ASX.
Before we go over two valuation models that you could use to answer the question yourself, let’s see why investors like bank stocks in the first place.
Along with the tech and industrial sectors, the financial / banking sector is one of the favorites for Australian investors. The largest banks, including Commonwealth of Australia Bank and National Bank of Australia operate in an “oligopoly”.
And while large international banks, such as HSBC, have tried to encroach on our âBig Fourâ, the success of foreign competitors has been very limited. In Australia, ASX bank stocks are particularly preferred by dividend investors seeking postage credits.
Comparable valuations with PE
The price-to-earnings ratio or âPERâ 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. Therefore, the âP / Eâ ratio simply compares the stock price to the company’s most recent annual earnings. Some experts will try to tell you that âlower PE ratio is betterâ because it means that the stock price is âlowâ compared to the profits generated by the company. However, stocks are sometimes undervalued 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 think it’s worth digging deeper than just looking at the PE ratio and thinking âif it’s less than 10x, I’ll buy itâ.
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’re looking at with its peer group or competitors and try to determine if the stock is. overvalued or undervalued compared to the average. From there, and using the principle of reversion to the mean, 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 ($ 104.95), along with its fiscal 2020 earnings (or earnings) per share data ($ 4.706), we can calculate the PE ratio of l company at 22.3x. 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 âsector adjustedâ PE valuation of $ 116.98.
Using dividends as an indicator of cash flow from ABC to equity investors
The dividend discount model or DDM is different from ratio valuation like the PE because the model predicts the future and uses dividends instead of profits. Since the banking sector has been shown to be relatively stable with regard to stock dividends, the DDM approach can be used. However, we wouldn’t use this model for, say, tech stocks.
Basically, we only need one entry in a DDM model: dividends per share. Next, we make some assumptions about the annual dividend growth (eg 2%) and the risk level of the dividend payment (eg 7%). We used the most recent full year dividends (e.g. last 12 months or LTM) then assumed dividends remain constant but increase slightly.
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 âriskâ 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 âriskâ rate, the lower the valuation of the share price.
We 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 âadjustedâ 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 $ 104.95. Since the company’s dividends are fully franked, you can choose to make an additional adjustment and valuation on the basis of a âgrossâ 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 predicts $ 101.92.
Key information and where to go from here
Please note that these valuation methods are just the starting point of the research and evaluation process. Please remember this. Banks are very complex businesses, and if the 2008/2009 GFC taught investors anything, it is that even the âbestâ banks can close their doors and drag shareholders with them.
If you are researching Commonwealth Bank of Australia stocks and considering an investment, take the time to learn more about the bank’s growth strategy. For example, is she looking for more loans (i.e. interest income) or more non-interest income (fees for financial advice, investment management, etc.)? Then take a close look at economic indicators such as unemployment, house prices, and consumer confidence. Finally, it is always essential to take stock of the management team.