ASX 200 Bank Review: Commonwealth Bank of Australia (ASX: CBA) Stocks at a Glance
In this article, let’s review two common valuation tools that an ASX bank equity analyst would use to provide his “target” on a company like Commonwealth of Australia Bank (ASX: CBA).
As you can imagine, this is the “easy version”. But “easy” is not synonymous with “good”. So, at the bottom, we will provide additional resources as well as potential indicative valuations. Basically, it goes without saying, but these valuations are not guaranteed.
Bank stocks like the Commonwealth Bank of Australia, ANZ Banking Group (ASX: ANZ) and Macquarie Group Ltd. (ASX: MQG) are very popular in Australia as they tend to have a stable dividend history and often pay postage credits.
As we explain the basics of investing in bank stocks in this article, if you want to understand the value of dividend investing in Australia, consider looking at the video from the Rask Australia teaching team.
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How to use ratios
The PE ratio compares a company’s stock price (P) to its annual earnings per share (E) (note: “profit” is another word for profit).
There are three easy ways to quickly use the PE ratio. First of all, you can use “gut feeling” and say “if it’s low I’ll buy stocks” or “if it’s above 40x I’ll sell stocks” (which is fine 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 expensive or less expensive? Third, you can take the earnings / earnings per share of the company you are valuing and multiply that number by any multiple of PE that you think is appropriate. For example, if a company’s earnings per share (E) were $ 5 and you think the stock is “worth at least 10 times its profit,” it would have a valuation, in your opinion, of $ 5 x 10. = $ 50 per share.
Using CBA’s stock price today, along with its fiscal 2020 earnings per share data, we can calculate the company’s PE ratio at 23.5x. This compares to the average banking sector PE of 24x.
By reversing the logic here, we can take the earnings per share (EPS) ($ 3.68) and multiply it by the “average” valuation of the CBA. This results in a valuation of the “adjusted by sector” share of $ 87.83.
Valuing Dividends (A Simple Guide)
A dividend discount model or “DDM” is a more robust way to assess companies in the banking industry.
DDM valuation models are among the oldest suitable valuation models used by analysts or professional 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. from the last 12 months or LTM), or the expected dividends for next year, and then assumes dividends remain constant or increase for the forecast period.
For simplicity’s sake, let’s assume that last year’s dividend payments are consistent. Important Disclaimer: Last year’s dividends are not always a good contribution to a DDM as dividends are not guaranteed as things can change quickly within a company. So far in 2020, the major Australian banks have reduced or deferred their dividends.
To make this easy to understand, using our DDM, we will assume that the dividend payment increases at a constant rate in perpetuity (i.e. forever) at an annual rate between 2% and 3%.
Next, we need to choose an annual “risk” rate to discount dividend payments in today’s dollars. The higher the “risk” 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 $ 47.28. However, using an “adjusted” dividend payment of $ 3.37 per share, the valuation drops to $ 60.41. The valuation compares to the Commonwealth Bank of Australia share price of $ 86.37.
Obviously, simple models like these are handy tools for analyzing and valuing a bank stock like the Commonwealth Bank of Australia. They can even make you feel warm and confused inside because you “valued” them.
Having said that, this is far from a perfect assessment. While no one can ever guarantee a return, there are things you can (and probably should) do to improve valuation before you see it as a valid yardstick.
For example, studying the growth of loans on the balance sheet is a very important thing to do: if they grow too fast, it means that the bank could take too much risk; too slow and the bank might be too conservative. Then study the rest of the financial statements for risks.
Areas to focus on include provisions for bad debts (income statement), their bad debt valuation rules (accounting notes) and sources of capital (wholesale debt markets or customer deposits). On this last point, note how much it costs the bank to raise capital in its business to lend to customers, keeping in mind that overseas debt markets are generally riskier than customer deposits. due to exchange rates, regulations and the volatile nature of investment markets.