It's important to think about a company's business before buying shares in it. Unfortunately, some new investors can be quick to buy the familiar names like Commonwealth Bank of Australia (ASX: CBA), Telstra Corporation Ltd (ASX: TLS), and Rio Tinto Limited (ASX: RIO) without considering the businesses behind them.
When you're just starting investing, nobody expects you to be an expert. Guaranteed, you'll make a few mistakes. Yet you can increase the likelihood of a good outcome for yourself by asking a couple of simple questions. If you're looking at Commonwealth Bank shares today, here are three things I would consider first:
- Where does the money come from?
Loans, obviously. Also insurance, superannuation, financial advice, and many other financial products like credit cards and personal loans. Prospective investors want to ask: 'Can this company earn more profits by writing more loans and selling more financial products in the future?' They could do this either by beating competitors like Westpac Banking Corp (ASX: WBC), or through a growing housing market and demand for debt.
In basic terms higher levels of employment, rising wages, higher construction activity, lower interest rates, and higher consumer confidence (among other factors) result in more lending activity.
- What are the company's bad debts like?
There's no point to lending if the people you lend money to aren't paying you back. Investors will have to do a little digging here, but you should be able to find an overview of Commbank's credit quality in its biannual or quarterly reports. Here is one from the September 2016 quarter:
Economic downturns don't happen overnight. It might take 2-3 years (or more) for the full impact of lower employment and higher bad debts to work their way through to a company's profits and share price. Even if you know nothing about banking, rising bad debts are a good warning sign.
- Valuation
Look at the company's Price to Book (P/B) ratio. You can usually find this information on your brokerage website. Commonwealth Bank has a P/E of 2.32, which means that its current share price of $81 is 2.32 times the value of its 'book' (its assets) of $35.20 per share, according to Nabtrade. Try to compare this to its 'historical' book value, or to other banks' book values to form an opinion on whether Commonwealth Bank is expensive. Many investors suggest paying much less than 2x book value for banks.
Of course the more you pay, the less you receive in return.
Foolish takeaway
Investors commonly buy banks for the perceived safeness and the almighty dividends – yet both of these things depend significantly on the factors discussed above. You can get a better grasp of the risks and possible benefits to a Commbank purchase by answering the three simple questions above.
