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The easy way to value bank shares

Using conventional valuation metrics like dividend yield and price-earnings ratio, major Australian bank shares currently look cheap.

The easy way to value bank shares

One way investors commonly assess the value of shares is by conducting a relative valuation.

For example, you may compare the price-earnings ratio of Commonwealth Bank of Australia (ASX: CBA), which currently stands at 14x, to the market average.

The price-earnings ratio or ‘P/E’ is simply share price divided by net profit per share. In theory, the less you pay for earnings (also known as profit), the better.

Using a third party website or brokerage account you can find the Australian ‘market’ or S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) average price-earnings ratio. Currently, the average of all 200 companies in the ASX 200 is 16x.

Obviously, having the two numbers side-by-side makes comparison easy, and we’d conclude that Commbank shares (14x) look cheaper than the market (16x).

Here are the other major banks’ price-earnings ratios:

We could say, from this basic information at least, that ANZ shares currently have the lowest valuation of the major four banks.

What does the P/E say?

Going one step further, many investors would evaluate the two components that make up the price-earnings ratio.

The ‘earnings’ in the ratio are usually calculated from last year’s results. That means, if the share price has fallen since then, the price-earnings ratio will appear lower.

If earnings fall this year or next, however, the price-earnings ratio could expand again. In fact, it could turn out that you bought the most expensive bank share when you thought you were buying the cheapest!

One way investors can counter this issue is by using analysts’ forecasts for earnings. The Thomson Reuters website, among many others, provides consensus forecasts from the analyst community on many different financial measures, including earnings.

But before you take analysts’ forecasts as a guarantee, keep in mind that empirical research has found the chances of analysts’ forecasts being within plus or minus 20% of the actual result after two years is less than 50%.

Foolish takeaway

There are many ways to value bank shares, and the price-earnings ratio method is arguably the easiest.

However, it is also the least robust measure for valuing bank shares, in my opinion. In fact, if an advisor told me to buy a bank share solely because it had a low P/E, I would be looking for a new advisor quick-smart.

All share valuations must be backed up by rigorous qualitative research on the business, its industry and the risks inherent.

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Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned. Owen welcomes -- and encourages -- your feedback on Google+, LinkedIn or you can follow him on Twitter @ASXinvest.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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