A target valuation of the Commonwealth Bank of Australia (ASX: CBA) share price can be equal parts art and science. That said, the research and valuation process is arguably the most vital part of successful investing and should not be neglected.
Let’s take a look at how we could value CBA shares.
Commonwealth Bank of Australia or just CBA for short is Australia’s largest bank, with a leading market share of mortgages (20%+), credit cards (25%+) and personal loans. It has over 15 million customers with most of them in Australia. Basically, it is entrenched in the Australian payments ecosystem and financial marketplace.
CBA share price
#1. Culture
For long-term investors looking to invest in great companies and hold them for 5, 10 or 20 years, at Rask we think it’s fair to say that a good workplace and staff culture can lead to improved retention of high-quality personnel and, in turn, long-term financial success of a company.
#2. Loans
ASX bank shares such as CBA need deposits and good profit margins to make their business profitable. Meaning, a bank gets money from term deposit holders and wholesale debt investors and lends that money to homeowners, businesses and investors. The difference between what a bank pays to savers and what it makes from mortgage holders (for example) is the net interest margin or NIM. Remember: when it comes to NIMs, the wider the margin the better.
If you are planning to forecast the profits of a bank like CBA or Macquarie Group Ltd (ASX: MQG), knowing how much money the bank lends and what it makes per dollar lent to borrowers is essential. That’s why the NIM is arguably the most vital measure of CBA’s profitability. Across the ASX’s major bank shares, we calculated the average NIM to be 1.87% whereas Commonwealth Bank of Australia’s lending margin was 1.99%, meaning the bank produced a better-than-average return from lending money to customers versus its peers.
The reason analysts study the NIM so closely is because Commonwealth Bank of Australia earned 85% of its total income (akin to revenue) just from lending last year.
#3. Why CBA’s ROE is key
#4. Understanding the Commonwealth Bank of Australia CET1 ratio
For Australia’s banks, the CET1 ratio (aka ‘common equity tier one’) is paramount. CET1 represents the bank’s capital buffer which can go towards protecting it against financial collapse – basically, it’s the proportion of total assets that are ‘liquid’ or readily available. According to our numbers, Commonwealth Bank of Australia had a CET1 ratio of 12.3% last year. This was better than the sector average.
#5. Share price valuation using dividends
A dividend discount model or DDM is one of the most efficient ways to create a forecast of ASX bank shares. To do a DDM we have to take the bank’s last full year of dividends and then apply a risk rating. Last year the total dividend was $1.75. Let’s assume the CBA dividend payment grows at a consistent rate each year into the future, somewhere between 2% and 4%. We will use multiple risk rates (between 6% and 11%) and then average the valuations. The calculation we use is: Share price = full-year dividend / (risk rate – dividend growth rate).
Growth rate
2.00%
3.00%
4.00%
Risk rate
6.00%
$41.50
$55.33
$83.00
7.00%
$33.20
$41.50
$55.33
8.00%
$27.67
$33.20
$41.50
9.00%
$23.71
$27.67
$33.20
10.00%
$20.75
$23.71
$27.67
11.00%
$18.44
$20.75
$23.71
According to this quick and simple DDM model, an estimated average valuation of CBA shares is $79.03. However, using an ‘adjusted’ dividend payment (the expected future dividend) of $4.74 per share, which is the preferred measure because it uses forecast dividends, the valuation goes to $80.56. The valuation compares to CBA’s current share price of $159.73. Since the company’s dividends are fully franked, we can make a further adjustment and do a valuation based on a ‘gross’ dividend payment (this is the value of the dividend including the franking credit). Using gross dividend payments, the ‘fair value’ projection becomes $115.08.
What this means is that the CBA share price might seem expensive using our simple DDM model, but this is just one of many steps you should take before making an investment decision. It’s important to consider all of the risks and ideas we presented here, including the benefit of rallying dividends and the good impact of franking credits.
