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Date : 05/12/2022

Commonwealth Bank of Australia

ASX :

CBA

Market Cap : $180.44 Billion

Dividend Per Share : $3.85

Dividend Yield : 3.59 %

Hold

52 Week Range : $86.98 - $109.20

Share Price : $106.95

CBA is a core holding within most high-quality dividend portfolios. Although the shares aren’t particularly cheap currently, we recommend Hold the stock, rather than try and time short term movements for potentially little or no benefit and risk crystallising large capital gains tax liabilities.

Company Analysis

Commonwealth is Australia’s Largest and Arguably its Best Bank

Commonwealth Bank, CommBank, is the second largest company on the Australian stock exchange and the largest of Australia’s four major bank oligopoly, or the ‘Big Four’. The Big Four control around 75% of business and consumer lending in Australia, are a critical component of the Australian economy, and are heavily regulated. The ‘Four Pillars’ policy prevents mergers between the Big Four and their acquisition by an overseas acquirer. This ensures a degree of market competition, but the oligopolistic nature of the industry underpins a competitive advantage for the Big Four over other market participants.

CommBank has heavily and successfully invested into its core banking technology over the past 20 years which has enabled relatively good customer service levels. The firm has also simplified via the divestment of various non-banking businesses such as insurance, wealth management, and funds management, enabling an increased focus on core banking activities. CommBank’s share price has performed relatively well over the past decade, as shown in Figure 1, which reflects superior earnings growth due to the firm’s relatively high quality.

Economic and Industry Outlook: The Australian Banks Are Well Positioned for Economic Weakness

As the second largest company on the ASX, and the largest bank in Australia, CommBank’s earnings are extremely diversified across the economy, meaning earnings growth is highly linked to economic growth. The Australian economy has recovered well following the coronavirus pandemic, with gross domestic product, or GDP, reaching record levels in recent months. However, the strong economy has helped drive high inflation and caused a very sharp increase in interest rates.

From CommBank’s perspective, rising interest rates will benefit earnings because they enable higher net interest margins, or NIM, on the bank’s loans. The potentially negative consequence of higher interest rates is that they will likely slow the economy and potentially cause a recession and an increase in bad debts for banks. Rising interest rates also tend to have a negative effect on real estate values, and Australian real estate prices are currently falling.

However, we believe that the Australian economy is sufficiently strong to avoid a recession and a significant increase CommBank’s bad debts. Although credit growth is likely to slow, this should be more than offset by rising NIM’s. The Australian banks and their customers are also better placed to weather an economic downturn currently than they were before the global financial crisis. For example, capital ratios are stronger, and a higher proportion of bank funding is from cheap and sticky customer deposits. From the customer’s perspective, unemployment is at 50-year lows and home equity levels are healthy.

Valuation: Equity Investors Are Well Aware of CommBank’s Attributes

Although CommBank is arguably the highest quality bank in Australia, it’s attributes are well appreciated by investors, resulting in its relatively high price to earnings, or PE, ratio, over the past decade, as shown in Figure 2. CommBank’s PE ratio premium to its peers has increased in recent years, which party reflects the growing value of its technological advantage over the other Big Four firms.

CommBank’s PE ratio increased to over 20 in mid-2021, which largely reflected market-wide PE ratio expansion, caused by near zero percent central bank interest rates. The sharp increase in interest rates over the past 18 months has impacted equity prices and PE ratios. However, CommBank’s PE ratio remains high relative to its long-term historical levels. We attribute CommBank’s relatively high PE ratio to its strong near-term earnings growth outlook for, due to the earnings benefits it is receiving as interest rates rise.

Earnings Outlook: CommBank’s Earnings are Highly Dependent on the Australian Economic Outlook

CommBank’s earnings are highly linked to the performance of the Australian economy. Key earnings drivers include national credit growth rates, market share gains, net interest margins, and bad debts. Generally speaking, if the economy is strong, loan growth is likely to be strong, interest rates are likely to be high, and CommBank’s profits will be strong. Conversely, if the economy is weak, bad debts are likely to rise, interest rates will likely fall, and CommBank’s earnings are likely to be impacted.

Although CommBank’s profits could be impacted by an economic downturn, we consider the long-term outlook for the economy to be good and therefore the long-term outlook for CommBank’s earnings to be good. We also expect Australia to avoid a recession in 2023, meaning we don’t expect CommBank’s earnings to be impacted in the short-term.

CommBank also has a competitive advantage, thanks to its cost advantage, due to its relatively low funding costs, and switching costs, due to the reluctance of banking customers to change bank. With over 16 million banking customers it has the largest single brand retail branch network, most active digital customers, and largest market share of home loans and credit cards.

As shown in figure 3, we expect NIM growth to drive strong revenue growth over the next couple of years, which should support solid earnings per share growth and fully franked dividend growth.

Dividends: Commonwealth Bank is a Very Reliable Source of Dividends

CommBank’s diversified and resilient earnings, and competitive advantages, mean the firm should be a reliable source of fully franked dividends over the long term. Figure 4 shows the CommBank’s dividends per share in recent years, and our forecasts, all of which are fully franked.

CommBank’s dividend growth slowed between 2016 and 2019 as falling interest rates impacted the firm’s net interest margins, or NIM, a critical source of income for the bank. Dividends also fell sharply in fiscal 2020 as the firm’s profits were impacted by near zero percent interest rates, which impacted NIM, and higher loan loss provisions. However, the sharp rise in interest rates over the past 18 months has enabled NIM and dividends to recover and we expect profits and dividends to continue to improve over the coming years.

Coronavirus pandemic aside, we consider CommBank’s dividends to be highly sustainable. Although the firm’s earnings and dividends are susceptible to economic weakness, we expect the Australian economy to grow over the medium and long-term meaning we also expect Commonwealth’s profits and dividends to grow. CommBank’s dividend payout ratio is also sustainable. As shown in Figure 5, dividends are comfortably covered by earnings. We also consider management’s approach to dividends, and the dividend payout ratio target of 70% to 80%, to be sustainable.

Commonwealth Bank’s dividend yield is currently around 4%, or around 7% including franking credits, which is somewhat lower than its historical trading range of between 5% and 6% in recent years, as shown in Figure 6. However, we believe this reflects market expectations that the net interest margin, profits, and dividends will grow in the coming years, meaning the dividend yield is arguably effectively around historical trading levels.

Figure 6 also shows the 10-Year Australian government bond yield, which is widely considered to be an investment which has no investment risk. The valuation of all assets are theoretically valued relative to this ‘risk free’ yield, meaning when it’s yield rises, or falls, all other yields should also rise, or fall, respectively.

The chart shows the convergence of the 10-year bond yield with Commonwealth Bank’s dividend yield, which is arguably a cause of concern. In theory, Commonwealth Bank’s shareholders are not being sufficiently compensated for the risk of investing in its shares. However, the expected growth in Commonwealth Bank’s dividends, means that its dividend yield is arguably higher. Also, the market is arguably pricing Commonwealth Bank based that the long term yield on the 10-year government bond is likely to be closer to the reserve Bank of Australia’s theoretical ‘neutral rate’ of around 2.5%.

Technical Analysis: Share Price Pushing All Time High Resistance Level

From a technical analysis perspective, Commonwealth Bank appears to be at a key resistance level around A$ 110 per share, which is the prior all-time high for the stock reached on 8th November 2022, as shown in Figure 7. The share price could therefore either remain in a range between the A$ 90 support level and A$ 110 resistance or push through the A$ 110 level to new all time high levels, which would be bullish. Considering the likely scenarios appear to be either a share price consolidation in the A$ 90 to A$ 110 level, or a breakout to new highs, and that the share price is above its 200 day moving average, we consider the technical analysis picture to be neutral to bullish currently.

Recommendation: We Recommend Long Term Investors Should Hold onto Commonwealth Bank Shares

Commonwealth Bank’s share price has performed relatively well in recent months and it’s PE ratio is relatively high. However, we expect earnings growth to be strong over the next couple of years and we consider the firm to be the highest quality bank in Australia. Although the share price could experience some short-term weakness, we consider the long-term outlook to be good and recommend long-term investors Hold the stock, rather than try and time short term movements for potentially little or no benefit and risk crystallising large capital gains tax liabilities.

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