Consensus community valuation
To be upfront, I’m a holder of CBA in real life (4.4%). I’ll try not to let that influence my valuation of the business. @Strawman has already covered the FY24 result and has pointed out how expensive CBA looks on both PB (price to book) and PE ratios. @juneauquan pointed out that the PB usually sits between 2-2.5 (currently 3.16) and the last time CBA's PB ratio went above 3 was in March 2015. Share price at this time rallied to $96.
While we’ve been focusing on PE, PB and NIM to determine a valuation for CBA, something more important has been changing without too much attention. I hate to be a stuck record, but yes it’s Return on Equity (ROE). Simply put that’s the annual return we get as investors for our share of equity in that business. In 2016 we earned 15.7% on our equity in CBA, and in FY24 we earned 13.1%. Yet we are paying an all time high for our share of equity (PB 3.16).
So the ROE has declined, but if our share of equity has increased then that could make up for it. The BV has increased in 8 years, but sadly the book value for CBA now ($43.70) is less than it was in 2021 ($44.40)!
I think using historical PE or PB to value businesses with increasing or declining ROE is too simplistic.
Let’s look at it another way to see if the valuation can be justified. Let’s give McNiven’sFormula a whirl! (See here for a brief explanation of the formula).
ROE for 2024 was 13.1%. What’s more important is what ROE will be going forward. Based on analyst consensus ROE could be 13.7% in 3 years time (Simply Wall Street data). For the purpose of valuation let’s be generous and assume forward ROE is 13.7%.
That means we are paying $138 for $43.70 in equity which is returning 13.7% per year.
Our valuation using McNiven’s Formula depends on our required return. Paying $138 per share for CBA you might expect a return of 6.7% (including franking credits). That’s a mere 1.7% premium to a term deposit for a hell of lot more risk! Perhaps buying an ETF like VAS would give you a better return with a lower level of risk? Mind you, you would be still getting a big chunk of CBA in VAS!
So what annual return would you be happy with to hold Australia’s so called “best bank”? Is an 8% annual return good enough to take the additional risk in owning CBA? Perhaps it is? After all it’s as solid as a bank gets!
For a required 8% annual return the valuation comes back to $110. I still think that’s a high valuation for CBA. Generally I would be looking for a solid growth business with ROE in excess of 20% to accept an annual return of 8%.
We sold another parcel of CBA on Friday (IRL). I’d like to sell the lot. The quandary we have, which probably explains why there are so few sellers of CBA even at such exorbitant prices, is the capital gains tax. Our cost price is $28 and the capital gain is $110 per share. We can’t sell our entire holdings without triggering a huge tax bill. @Solvetheriddle also talked about this. It makes sense to sell a few parcels each year and offset the gains with some loss making shares. That’s if these share prices continue. I can’t see how they can.
Held IRL 4.4%
The Risks of Buying CBA at a High PB ratio
Over the past ten years, the PB ratio of CBA hovers between 2-2.5. Currently it is 3.16
The last time CBA's PB ratio went above 3 was in March 2015. Share price at this time rallied to $96.
It took SIX years for share price of CBA to get back above $96 (May 2021)
I'm no fan of the banks, as I'm sure most of you know, but I always find their results material fascinating reading.
There's a lot of coverage out there, but I'll highlight some of the things i think are interesting.
The first thing to note is that CBA remains one of the most expensive banks in the world -- at a price-to-book of 3.1x, it represents more than double what you typically see for a bank.
Even JP Morgan's CEO Jamie Dimon said recently that “Buying back stock as a financial company, greatly in excess of two times tangible book [value] is a mistake. We aren’t going to do it”
P/B ratios tend to be the preferred measure for banks because of the fundamental importance of their balance sheets (well, that's always important, but it's super important for banks). Book value is less volatile than earnings and also gives a good read on lending capacity etc.
But even if you prefer a PE, 23x aint cheap either -- especially for a mature business that just reported a 6% drop in profits, and for which analysts are forecasting little to no growth in the coming years.
Yeah, yeah dividends blah blah blah, but is 3.5% ff (or about 5% grossed up) really that good? I mean, i can pretty much get that (virtually) risk free in CBA's own term deposits! Also, there's no growth in the dividends -- the compound annual growth rate in Divs per share over the last decade has been ~1.5%
Oh, and there's a nice reminder here that dividends can and do get cut from time to time.
I'll just remind you again that of all the loans the CBA makes, 70% are for home loans. 17% are business loans
Which makes it very hard to take Matt's assertion seriously:
Anyway, the maths is such that you only need an ~11% drop in the carrying value of their home loan book to entirely wipe out their equity. That's not likely to happen, which even a bear like me will admit, but it shows you how sensitive they are to the housing market. And you dont need much of a writedown to really take a knife to earnings.
(I will note that impaired and 90-day arrears metrics both moved in the wrong direction, with provisioning coming in 50% higher than the bank itself forecast).
Anyway, I can shake my fist at the sky all day long -- the fact is CBA has done very well in terms of share price in recent years (unlike its peers).
Still, low to no growth, highly sensitive to economic conditions and excessively valued.
Hard pass.
Hi @Rick, You peaked my interest as I gave up on Banks long ago. I used to be in one of those period where they didnt move and just went sideways. I now can see why it has moved to where it did (the good old 200% wvae 5). I also think the Analyst's just put targets in using fibonnacci number as they always (and I mean always) seem to land on a mix between Fibonacci levels, Support /resistance levels & sma's. Personally I like the $87 market.
Did some quick figures on it since listed on the market, it has gone up by x23.67 (from $5.66 ---> $134), in 32 yrs just on growth inc the 2008 crash & covid. So could have done even better if added more during those times and none of that includes Dividends or fully franked. Personally I would never have guessed ( i should have though, they are strong).
Index has a lot of miners so RoE I imagine swings with commodity price - but still tells a story.
Good overview of the majors - Bank reporting season scorecard (firstlinks.com.au)
The below graph is a bit scary being so low - good but gets worse/normalises? Been a really good few years for the banks in terms of bad debts and now reaping higher NIMs at the moment. Do bad debts come back to bite with higher rates?
The major 4 banks face relativley slow growth prospects so I think you can for the most part expect the future returns is likley to come from dividends.
What doesn't make much sense is that you can get a similar and in some cases better income return from major bank hybrids as the equity - see below. (the yield to reset uses the futures curve which may or may not be what does occur - but the running yield is the forward 12 month return). From what I've heard you can even get Tier 2 bank notes nearing yields on hybrids.
There's some interesting (risk/return) mispricing going on in bank capital stacks at the moment.
19-June-2022: CBA is Australia's second largest company (behind BHP) and is currently rated #283 here on Strawman.com (as I type this), having moved up the rankings a fair bit since their share price has reduced lately. It does say something about our primary focus here that a company like CBA rates so low in terms of people here who hold the company in their Strawman.com portfolio.
CBA is currently held here by only 4 Strawman Premium members. And I am not one of them. I have never held any of the big 4 banks in my SM portfolio.
Being the clear leader of the big 4 in terms of size and quality (and management also IMO), CBA is starting to look interesting from a price perspective:
$87.26 looks like a great price when you look at that, however when you zoom out and look at the 5-year chart...
...the pullback in 2022 hasn't been nearly so deep as the one in 2020, and I feel there is plenty of scope for that SP decline to continue further before they recover, purely based on sentiment around an impending Australian recession, and the rest of it. I think CBA is probably a decent BUY here, with a 5-year-plus view, but I think they're going lower and we'll be able to buy them even cheaper in the future, possibly the near future.
I found it interesting what FMG founder and major shareholder Andrew "Twiggy" Forrest said last week about the likelihood of a global recession this year - Andrew Forrest says no recession, but expects years of choppy markets (afr.com)
by Hans van Leeuwen, Europe correspondent
Last updated Jun 17, 2022 – 11.26am, first published at 10.36am
London: Fortescue Metals Group boss Andrew Forrest says there is “not a snowflake’s chance in hell” of a global recession this year, but warned that markets could be “choppy and uncertain” for up to three years.
Speaking to AFR Weekend during a visit to London, Australia’s richest man said Fortescue’s low cost base and its green energy plans left it well-placed to weather the storm of rising borrowing costs, soaring inflation and slower growth.
Andrew Forrest visited France this week to sign a deal for zero-emission trucks with manufacturer Liebherr.
He also shrugged off reports that China might create a centralised purchasing cartel to drive down iron ore prices, saying this was “a story which gets trotted out every three years”.
The Russia-Ukraine war has spurred sharp increases in energy and food prices. This has combined with rebounding post-pandemic labour markets and issues with supply chains and transport costs to fuel inflation.
“I don’t know of a better industry to be pivoting towards when fuel prices are going through the roof than an industry where you can make all your own fuel,” he said, referring to Fortescue’s ambitious plans to make hydrogen from renewable energy.
The prospect of rampant inflation has pushed central banks to start aggressively raising interest rates, sapping stock prices. Companies’ cost of capital may climb, deterring them from investing and expanding.
But Dr Forrest said Fortescue was relatively immune to these cyclical forces: it should still be able to raise capital, and could withstand any downturn in commodity prices.
“We smoke $3.5 billion worth of fossil fuel into the atmosphere every year. That is one hell of a pool of capital annually to invest into your own fuel production and green iron systems,” he said.
He also said there was still an abundance of capital looking for investible projects. “The largest part of that is for green projects, by a country mile. That’s not going to change.”
And even if the cost of capital rose or fell, “so does the commodity price”, giving him the revenue base he needs to push forward with his green transformation.
Fortescue plans to spend $800 million-plus to build an end-to-end supply chain for hydrogen and ammonia produced using only renewable energy, and is also investing in technology for hydrogen-powered or zero-emission ships, trucks and trains.
The biggest risk to Dr Forrest’s ambition would appear to be a drop in the price of iron ore, but he is not overly worried.
“Demand for our product has remained strong,” he said. “And if global demand for iron ore goes down, the last man standing will be the lowest cost producer. And that is Fortescue.”
‘Not a snowflake’s chance in hell’
Dr Forrest was not anticipating the kind of global recession that might sap demand for iron ore. He said there was “not a snowflake’s chance in hell” of that happening.
“From country to country, yes. But there’s pent-up demand from COVID and that’s now been exacerbated by the Russian invasion. And I think that demand is still going to be there,” he said.
“You are going to have a choppy two or three years; not recession, nothing hugely dramatic like a global recession. But markets are going to remain choppy and uncertain for two or three years.”
The other great uncertainty is geopolitical: the ever-lingering prospect of worsening relations between the US and China, with the potential for economic decoupling that might sweep up Australia even further.
Dr Forrest welcomed the Albanese government’s more temperate approach to relations with China as “a breath of fresh air”.
“I’ve really resented China being used in [Australian] politics,” he said.
He urged both Beijing and Canberra to “check their language” and make sure they were not creating an enmity by treating each other as enemies.
But his support for a détente with Beijing was based on “the public interest”, he said, as geopolitical tension was not a material concern for his business.
--- ends ---
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So back to CBA. There will likely be further downside from here, but at some point they will become worthy of serious consideration as part of a diversified portfolio, particularly one like mine that currently has zero banking exposure.
The sell-down of the banks (including CBA) is not entirely unjustified. They WERE quite expensive, especially CBA, and the outlook is changing, however they are NOT going broke, they are very well managed, and at some point I will likely buy some if the price keeps falling.
Also, while the banking landscape will continue to evolve, I would back CBA to keep themselves at the cutting edge of banking here in Australia, as they have done so far.
Source: AFR Banking Summit | Deloitte Australia
