The Commonwealth Bank of Australia (ASX: CBA) share price has outperformed every other Aussie bank over just about every time horizon you could pick (note that I'm excluding Macquarie Group (ASX: MQG) because it's more of an investment bank than a retail bank).

But what's a fair price to pay for CBA shares?

Recently, following the release of results from ANZ Bank (ASX: ANZ), National Australia Bank (ASX: NAB) and Westpac (ASX: WBC), I took to Selfwealth Live to review the big banks and discuss valuation.

Let's go!

It starts with dividends 

If I was valuing an industrial business, such as JB Hi-Fi Ltd (ASX: JBH) or Wesfarmers Ltd (ASX: WES), I would create a forecast for sales 5 or 10 years into the future, figure out the costs to paid and calculate a measure called 'free cash flow' (FCF). I'd use the cash flow figure to value the business today.

This is known as a Discounted Cash Flow (DCF) analysis, and it's the most popular analyst valuation method for industrial businesses.

However, banks are different to industrials, so we need something different.

Banks don't generate 'free cash flow' like an industrial does. And everything is back-to-front. For example, a bank's assets (e.g. loans) are a liability for industrial business. So they require a different way of valuing them.

That's why we use dividends for banks. That is, cash dividends paid to shareholders.

Basically, we:

1. Estimate next year's dividend payment;

2. Make an educated guess at how fast the dividend will grow long into the future (e.g. 3% per year);

3. Apply an expected return rate that we demand for owning the shares (e.g. 'given the risks, I demand a 10% per year return for investing my money in CBA shares') (in finance speak, we call this the "discount rate").

If it sounds simple, it's because it is.

(Obviously, as a professional analyst I would create a spreadsheet, do rigorous industry research and understand management's strategy before simply picking a dividend and a growth rate. But you get the idea.)

Using our numbered list above, the formula is this simple: 1 / (3 - 2) = valuation.

In other words, dividends divided by the risk rate less growth rate.

This is called a dividend discount model or DDM because we are discounting the future dividends back to today's dollars.

DDMs are the older Wall Street valuation tool. But like all valuation methods they use just as much art as they do science.

Let's apply the DDM so we know how it works...

CBA case study

To pick a dividend amount, you could use analysts' forecast dividends for next year as your dividend payment. You can find analysts' forecasts in the "forecast tab" for CBA inside Selfwealth. You can see below, the forecast for 2023 is $4.37.

However, not everyone has access to dividend forecasts (and they can be wrong). So let's keep it easy to use and assume last year's dividend payment ($3.85) from CBA grows at a constant average rate each year.

Let's assume the dividend grows at a sensible rate of 3% (0.03) per year -- in-line with the economic growth rate of Australia's GDP over time.

(Note: don't pick an aggressive growth rate because you're effectively saying 'the dividend grows at X% forever' -- which is a long time!).

Finally, the discount rate. We could get fancy with the discount rate / expected return, but I'll assume I want a 10% (0.1) return per year in order to own CBA shares. 10% sounds good, right?

Using our formula for the DDM method above, we have:

$3.85 / (0.1 - 0.03) = $55 valuation. 

However, we should also include the impact of franking credits because these tax credits are a real benefit to real shareholders.

Because CBA's dividends are fully franked, we can simply divide the dividend amount by 0.7 to get the gross amount. That is, ($3.85 / 0.7) $5.50.

Using the gross yield in our formula we have:

$5.50 / (0.1 - 0.03) = $78.57 valuation. 

What does it mean?

This is by no means a silver bullet for valuation or smart investing. Remember, garbage in, garbage out (GAGO).

And sometimes a tool (like share valuation models) are very dangerous in the hands of a novice (it's kind of like handing a teenager a power drill). So go slow, and remember valuation is more art/guesswork than it is science. 95% of my time is spent researching a business, the final 5% is valuation.

How to improve bank valuations 

If you decide to do the full financial modelling of a bank and its industry (like I would) you should try to do a scenario analysis (when you imagine different futures for the bank), and make sure you try a sensitivity analysis (using different inputs for growth and risk/expected return rates). You can see an example of this below.

Source: Owen Rask's forecasts, valuations are strictly for educational purposes only. They are not Owen's 'real' valuation.

Using this table, you could read it as follows:

• If I want a 9% return from CBA shares and I think CBA will grow its dividend its 2.5% per year, the right valuation is ~$84.62.

• If I want an 11% return from CBA shares and I think CBA will grow its dividend its 3% per year, a good price to pay might be around ~$68.75. Remember, a higher discount/expected return/risk rate means a lower valuation.

Of course, these are examples only.

But I did say that you would learn how to value a bank in 3 minutes...

To learn more, tune into Selfwealth Live every Wednesday night at 6 pm Australian Eastern Time, or watch the video above.

Cheers!

Owen Rask