‘Dizzying’ is an appropriate adjective to describe the share price of Commonwealth Bank of Australia at the moment.
In December 2012, the stock of Australia’s largest bank by market capitalisation broke through the $60 mark, a value it had only previously reached during the 2007 run-up to the global financial crisis. As it pushed through the heady $70 mark this week, with little sign of abating, investors are wondering how far it can go.
Indeed, the share prices of all of the big four banks with the exception of National Australia Bank are trading above or close to pre-2008 highs..
While most shareholders seem happy to own bank shares for the generous dividend attached to them – worth an average 7.1 per cent of their underlying investment at present – the question of whether banks are fully valued at their current share prices continues to linger.
“They have run up very hard, and a lot of commentators already think they have run up too hard,” says David Ellis, head of bank analysis at the Australian arm of research house Morningstar.
Based on historic valuation comparisons, there is an argument to be made that the banks are beginning to look expensive.
On a price-earnings ratio basis, the banks on average will be trading at almost 13 times earnings at the end of 2013, with CBA expected to be trading at 14.2 times, according to Morningstar forecasts for the next three years.
The average PE multiple for the big four during the past 10 years as calculated on a daily basis is less than 13 times earnings, Ellis says.
The PE multiple is generally a reflection of how much investors are willing to pay for the company’s current or expected earnings and will differ by industry and sector.
Similarly, based on a price-to-book valuation, the forecast average for the second half of 2013 of the big four is at the top end, Ellis says. CBA is forecast to be the most expensive based on this metric at 2.4 times by the end of this year. The price-to-book valuation measures the bank’s net asset value on a per-share basis.
As a comparison, most banks in Europe and the United States are lucky to trade on a price-to-book valuation of 1, Ellis points out.
Also, the banks’ dividend yields have begun to level out. The average fully franked dividend paid by the four banks was 7.1 per cent in 2012 and is expected to be closer to 6 per cent in 2013, and the same in 2014, according to Morningstar forecasts.
Dividends are useful for banks and companies generally, in terms of building support for their stock, and have particular appeal to the growing community of self-managed super fund trustees who seek out yielding investments and hold a high proportion of direct shares.
More room to run
Despite all the measures that show bank stocks are expensive, there is still evidence the big four’s shares have the potential to continue their run this year.
The banks’ cost of capital will continue to improve or at least remain stable, says Bell Potter Securities banking analyst TS Lim.
Lim says that expected improvements in the domestic economy, coupled with the uptick in equities markets, will help boost earnings in the banks’ business banking and wealth management business areas.
Bank margins have been gradually improving since the global financial crisis, as wholesale funding costs have gradually fallen, Lim says. He notes the spreads on swap rates that were as wide as 200 basis points in 2008 have narrowed to as much as 95 basis points and he expects those wholesale funding rates to continue to improve.
“Over the next six to 12 months we expect to see margins [on bank funding] continue to stabilise,” he says.
Lim also thinks the banks’ respective wealth management businesses will provide a kicker to earnings should investor appetite for the equities markets return. Of the four banks, CBA has the largest exposure to wealth management, making up 9 per cent of the bank’s earnings. Westpac has the next largest wealth management exposure, followed by NAB and ANZ.
NAB could be the best value play among the big four banks, not only because of the discount that it is trading at compared to its peers, but also because the bank could be more leveraged to a domestic economic recovery given its exposure to business banking, says Perpetual portfolio manager Vince Pezzullo.
NAB has the largest business banking business in the country.
Its biggest challenge will be to manage its exposure to the British business that has been the biggest drain on its earnings, Pezzullo notes. NAB’s earnings per share have remained flat for the past 10 years. By contrast, CBA increased its EPS by 128 per cent in that time, while Westpac grew its EPS by 90 per cent, and ANZ 65 per cent.
While CBA’s relative valuation means the stock might have less headroom than its competitors, Lim believes even CBA has the ability to continue to improve its return on equity this year, which he says is fundamental to its share price performance.
Not everyone agrees – in fact, few do. Only three out of 17 sell-side analysts who follow the stock recommend buying CBA, according to Bell Potter research, with six holds and eight sell recommendations.
Despite the relative strength of CBA’s earnings, the big bank has become an unlikely contrarian play. Analysts that recommend holding or selling point to the already full valuation of the stock.
Yet it’s worth remembering how impervious to competition Australia’s big banks have proven to be, and that they receive government support that is the envy of banks in other countries.
For instance, from 2015, the banks will be able to access a so-called committed liquidity facility, essentially a taxpayer-funded line of credit priced just above the cash rate, allowing them to satisfy stringent new liquidity tests demanded by Basel III regulations.
According to CLSA banking analyst Brian Johnson, the facility essentially means the big four banks can never run out of cash.
Suddenly, the prospects for CBA share price growth seem brighter.
With Michael Bailey