Commonwealth Bank (CBA) has been a popular inclusion in many Australian investors’ portfolios. We are concerned that its soaring share price is a sign of a market bubble that is about to burst and could have impact to both income and accumulation portfolios.
The CBA share price at $152 and Price to Earnings ratio (P/E) of 25x (at the time of writing) are defying the fundamental laws of gravity that typically bind Australian banks to a P/E discount to the broader market. This is because banks typically have more limited earnings growth capabilities due to their regulated capital base, and lower Return on Equity & earnings tail risk from credit losses. While CBA did have some good earnings growth in the 2000s, the more recent decade has seen it grow well below inflation and the market, with EPS up just 4% in total over the last 10 years.
It is often said that a company can grow into its P/E, but to us, what makes CBA’s valuation look extreme compared to other high P/E names is that CBA is only likely to grow Earnings Per Share (EPS) around 2% p.a. vs. stocks with a similar P/E such as CSL or Goodman Group. We believe that these stocks are likely to be able to grow EPS at a double-digit rate at least for a few years. CBA’s structural slowdown in EPS growth is driven by several factors: the high indebtedness of the Australian consumer today, stakeholder focus on fees, competition from new technology, stricter capital and liquidity requirements from APRA, and mortgage discounting that has built an impairment into net interest margins over the residual mortgage loan life. With expected growth of 2% p.a., it could take more than 20 years of zero share price appreciation to get back to a more typical P/E ratio.
With the share price where it is, the yield for CBA has also now dipped below the bond yield. And with the buy and hold return (IRR) estimate sitting near 5% (based on the 3% dividend yield and 2% expected growth), why should an income investor take on additional equity risk over cash or bonds? Even CBA themselves seem to think this, having paused buybacks as their preferred way to return capital to shareholders as a buyback is dilutive to the dividend per share (DPS).
We must keep reminding investors that we are talking about a bank, a sector which is often perceived as slow and boring. This CBA bubble is not about a strong expected earnings growth story like Xero, CSL or Nvidia. One important thing that does appear to be driving the euphoria for this stock is the weight of inflows into index funds. The investment market is experiencing several trends: outflows from active funds, strong inflows to index funds, super fund inflows in a rising market, and a focus on short term risk management due to the Your Future Your Super performance test. Additionally, there is a preference for stocks not exposed to China. These factors are creating “more buyers than sellers” in CBA, driven by its >10% S&P/ASX 200 index weight, general underweight positions among active managers, and a strong retail shareholder base.
Whilst these trends can ‘ex-post’ explain CBA’s outperformance, they don’t explain what a fair value price is for CBA and whether it is a bubble subject to the whims of one of these buying forces.
But the real question is what's going to happen next - can the CBA share price really keep rising in such an extraordinary manner despite the lack of earnings growth? Is it prudent to be investing in a stock with, on our bottom-up fundamental estimates, a greater than 40% valuation downside to its current share price? (See Key Chart 1)
History has repeatedly shown that periods of euphoria unwind and often give way to an unexpected regime change when the imbalance in the system eventually makes it fall over. Our valuation spreads for CBA, and the Australia market as a whole (See Key Chart 2) suggest that we are close to this inflection point.
Importantly, Value-style stocks have typically produced significant alpha in the 12-24 month periods following such inflection points. We believe investors really need to be thinking much more about the fundamentals and their position, or lack of position, in value-style stocks.
Key Chart 1
The following chart highlights three ways to consider how the stock price of CBA (grey bars) has surpassed the fair value of the stock by around 40%:
- The slate-coloured line is a simple multiple calculation using broker forecasts of CBA’s next twelve month (NTM) EPS at each point in time multiplied by 15x, the long-run P/E ratio.
- The red line uses another ‘rule of thumb’ valuation measure and shows the expected share price if the company were valued based on its DPS and a simple 5% unfranked yield, a typical level for the company pre-2020.
- The green line is what our MCA research analyst has valued CBA at with their full bottom-up fundamental analysis of fair value at each point in time.
Price vs. Fundamentals: CBA
Key Chart 2
Our team’s record of more than 20 years of in-house fundamental valuations of Australian companies provides great insight in understanding the scale of the opportunity for Value stocks within the market.
Our valuation assessment of CBA (see left chart), and also the S&P/ASX 200 as a whole, suggest that both are at/near their most overvalued point since our records began, and that we expect future returns to be negative over the medium term. Accordingly, we hold an underweight position in the stock in our MCA Value Equity strategy, and have significantly different holdings to the index in our portfolios.
We can also use our valuations to measure the overall opportunity for alpha for our MCA Value Equity strategy. The spread between our valuations for our holdings and stocks in the S&P/ASX 200 (see right chart) has only exceeded +40%, a critical threshold that signifies an extreme value opportunity, in periods such as the GFC and Covid (shaded in grey). From this wide level, the MCA Value Equity strategy has historically produced significant alpha over the S&P/ASX 200 Accumulation Index over a full style cycle.
MCA Valuation Spread:
CBA vs. S&P/ASX 200
Learn more about Martin Currie Australia and our Value Equity strategy below
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Martin Currie Australia
Leading innovator of Australian Equity,
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Value Equity
Active value focus for
long-term capital growth.
Sources
Past performance is not a guide to future returns. The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
Source: MCA, FactSet; as 14 January 2025.
Data shown for a representative MCA Value Equity account vs. S&P/ASX 200 Index. *Expected next 12 Months (NTM) data is calculated using the weighted average of broker consensus forecasts of each portfolio holding – because of this, the returns quoted are estimated figures and are therefore not guaranteed and may differ materially from the figures mentioned. The figures may also be affected by inaccurate assumptions or by known or unknown risks and uncertainties. In respect of the broker consensus data the number of brokers included for each individual stock will vary depending on active coverage of that stock by a broker at any point in time. A median of brokers is typically utilised. All estimates avoid stale forecasts which are removed after a certain number of days.
**Long-run P/E ratio of the Australian market
Important information
This publication is issued for information purposes only and does not constitute investment or financial product advice. It expresses no views as to the suitability of the services or other matters described in this document as to the individual circumstances, objectives, financial situation, or needs of any recipient. You should assess whether the information is appropriate for you and consider obtaining independent taxation, legal, financial or other professional advice before making an investment decision.
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Some of the information provided in this document has been compiled using data from a representative account. This account has been chosen on the basis it is an existing account managed by MCA, within the strategy referred to in this document. Representative accounts for each strategy have been chosen on the basis that they are the longest running account for the strategy. This data has been provided as an illustration only, the figures should not be relied upon as an indication of future performance. The data provided for this account may be different to other accounts following the same strategy. The information should not be considered as comprehensive and additional information and disclosure should be sought.
The information provided should not be considered a recommendation to purchase or sell any particular strategy / fund / security. It should not be assumed that any of the securities discussed here were or will prove to be profitable. It is not known whether the stocks mentioned will feature in any future portfolios managed by MCA. Any stock examples will represent a small part of a portfolio and are used purely to demonstrate our investment style.
Risk warnings - Investors should also be aware of the following risk factors which may be applicable to the strategy shown in this document.
- Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment.
- This strategy may hold a limited number of investments. If one of these investments falls in value this can have a greater impact on the strategy’s value than if it held a larger number of investments.
- Smaller companies may be riskier and their shares may be less liquid than larger companies, meaning that their share price may be more volatile.
- The strategy may invest in derivatives (index futures) to obtain, increase or reduce exposure to underlying assets. The use of derivatives may restrict potential gains and may result in greater fluctuations of returns for the portfolio. Certain types of derivatives may become difficult to purchase or sell in such market conditions.