ASX bank shares make up around one-third of the Australian stock market, as measured by market capitalization and the All Ordinaries Index.
Within the financial sector, ASX bank shares are by far the most popular. We will go through the absolute basics of valuing a bank share like Commonwealth Bank of Australia. If you’re really interested in understanding more about how to value a bank share, you should consider watching this tutorial from the Rask Australia analyst team.
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Using the PE report for ratings
The price-to-earnings ratio or “PER” compares a company’s stock price (P) to its most recent full-year earnings per share (E). Remember, “earnings” is just another word for profit. So, the ‘P/E’ ratio is simply comparing the share price to the company’s most recent full-year earnings. Some experts will try to tell you that “lower PE is better” because it means the stock price is “low” relative to the profits the company produces. However, sometimes stocks are undervalued for a reason!
Second, some very successful companies have gone for many years (a decade or more) and never reported a book profit, so the PE ratio wouldn’t work.
Therefore, we think it’s helpful to dig deeper rather than just looking at the PE ratio and thinking to yourself “if it’s less than 10x, I’ll buy it.”
One of the simple ratio models that analysts use to evaluate a bank stock is to compare the PE ratio of the bank/stock you are looking at against its peer group or competitors and try to determine whether the stock is overvalued or undervalued relative to to medium. From there, and using the mean reversion principle, we can multiply the earnings/earnings per share by the industry average (E x PE sector) to reflect the average value of a company. It’s like saying “if all other stocks are priced at ‘X’, this should be too.”
If we take CBA’s share price today ($105.82), along with earnings (aka profits) per share data from FY2022 ($5.43), we can calculate that the company’s PE ratio is 19, 5 times. This compares to the banking sector’s average PE of 15x.
Next, take earnings per share (EPS) ($5.43) and multiply it by the average PE ratio for the CBA (banking) sector. This translates into an “industry adjusted” PE valuation of $82.18.
CBA share price: dividends can be used
The dividend discount model or DDM is different from evaluating the ratio as PE because the model forecasts into the future and uses dividends instead of profit. Since the banking sector has proven to be relatively stable with regards to stock dividends, the DDM approach can be used. However, we would not use this model for, for example, technology shares.
Basically, we need only one input into a DDM model: dividends per share. So, let’s make some assumptions about the annual growth of the dividend (e.g. 2%) and the level of risk of the dividend payment (e.g. 7%). We then used the most recent full-year dividends (for example, from the last 12 months or LTM). assuming that dividends remain constant but grow slightly.
To make this DDM easier to understand, let’s assume that last year’s dividend payment ($3.85) grows at a fixed rate each year.
Next, 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 stock price valuation.
We used a mixed rate for dividend growth and a risk rate of between 6% and 11%, so we got the average.
This simple DDM valuation of CBA stock is $73.39. However, using an “adjusted” dividend payment of $4.37 per share, the valuation rises to $78.33. Valuation of the expected dividend compares to the Commonwealth Bank of Australia share price of $105.82. Since the company’s dividends are fully unpaid, you may choose to make a further adjustment and do the valuation based on a “gross” dividend payment. That is, the cash dividends plus postage credits (available to eligible shareholders). Using the expected gross dividend payment ($6.24), our valuation of the CBA stock price is expected at $111.91.
You may want to consider using these templates as a starting point for your own bank share evaluation and analysis process as a CBA. However, remember that these are just tools used by analysts, and in reality, a good analyst and investor will likely conduct 100+ hours of qualitative research before diving into their spreadsheet and starting modeling.
For example, we spend a lot of our time looking at and writing about bank stocks, but if we were thinking about investing in a bank today we would like to understand its growth strategy, economic indicators such as unemployment and then study house prices and consumer sentiment .