Chart of the Week: How overvalued is CBA compared to its peers?
This week’s chart looks at Commonwealth Bank of Australia’s valuation gap to peers.
This week’s Chart of the Week looks at CBA’s valuation comparative to peers. Our analysts believe that the bank’s valuation looks stretched and investors can find better value elsewhere.
All else equal, you’d pay more for a business generating higher returns on equity. But even the best business has a fair price, and CBA has long since surpassed it. We know this might sound like a broken record. We’ve questioned CBA’s valuation before, and yet the shares keep climbing. Its latest result met expectations, offering little to unsettle investors. But what the market is willing to pay for those earnings remains, in our view, unjustifiable. CBA now trades on 26 times forward earnings, with a dividend yield of just 3%.
We can speak generally about banks here. Bank moats are typically derived from two sources: cost advantages and switching costs. Cost advantage is an important source of the bank’s wide economic moat, and supported by a low-cost deposit base, operating efficiency, and conservative underwriting relative to peers. This means CBA are able to source funds at a lower cost. Their key funding cost advantage is the roughly 70% of funding which is sourced from customer deposits.
The rates that they offer on fixed term deposits are often higher than wholesale funding markets. Where they are making their money is when customers are holding funds in transaction or saver accounts that typically earn little or no interest.
This is supported by switching costs. It is a pain to switch backs and often leads to customers paying a loyalty tax. This is a tax for staying loyal to a bank – maybe it is because they’re lazy and they don’t want to look at other options. Maybe it is because of user experience – they like the experience they get with the bank, or the support. Maybe it is because they have multiple products bundled together that make them more sticky. For whatever reason, customers are staying in these accounts and it means that CBA have access to cheap loans and this helps with them maintaining their competitive advantage.
One other point to note is there is conservative underwriting relative to peers. This results in lower loan losses on average through the cycle. Given the commoditised nature of the industry, and competition for both loans and deposits, low costs is key to achieving excess returns.
On a forward price/earnings ratio above 25, 3% dividend yield and price/book ratio above 3.5, Morningstar analyst Nathan Zaia believes CBA shares are materially overvalued.
It is a strong business – a premium to peers is warranted due to the lower cost of funding and superior operating efficiency, but the gap is extreme.
Morningstar Market Strategist Lochlan Halloway asks investors to step back and look at ROE trends over the past decade. CBA hasn’t meaningfully pulled away from the other majors, yet investors are paying a much higher multiple than ever before, even as returns have drifted lower in line with the rest of the sector.
You’re able to find previous editions of Chart of the Week here.
