The largest and most profitable Australian bank is not immune from industrywide margin pressures. Commonwealth Bank (ASX: CBA) reported a third-quarter profit of $2.4 billion, down 3% on the quarterly average of the first half of fiscal 2024.

The decline is tracking marginally better than we expected, though, thanks to lower expense growth and bad debts. Bad debt expenses and arrears are low at 0.08% of loans, compared with our medium-term forecast of around 0.15%. While continuing to rise, home loans behind on payments are below historical averages, and we suspect equity buffers, the strength of the labor market, and strong house prices will keep actual bank losses manageable even as household stress rises.

Margin pressures from competitive loan and deposit pricing are easing, partially offset by better returns on capital and deposit hedges the bank holds thanks to higher interest rates. Adjusted for the number of days, income was flat in the quarter, with loan growth offsetting lower margins. Operating expenses were well contained, up 2%, with productivity improvements taking the edge off higher wages and amortization costs.

In the next five years, we assume pricing on loans and customer deposits allow for a modest margin improvement for the bank, and a return to loan growth in line with the market. Australian banks are currently generating poor home loan returns, dragging group returns on equity below 10% for most banks.

This supports our view that current loan and deposit price competition is elevated and unlikely to persist indefinitely. Assuming low-single-digit operating expense growth, Commonwealth Bank's return on equity (“ROE”) increases to 15.5% in fiscal 2028 from our forecast of 13.5% in fiscal 2024. We think our positive view on the outlook is more than priced in, though, with the shares at a material premium to our $90 fair value estimate. On a fiscal 2024 P/E of 20 times, price/book above 2.5 times, and dividend yield under 4%, we see better value in peers.

Our valuation

Our fair value estimate for Commonwealth Bank is $90 per share. We assume home loan growth slows in fiscal 2024 as higher cash rates affect demand and borrower capacity, and margins soften modestly. Commonwealth Bank is expected to make modest market share gains over the medium term, and we assume total lending growth averages 4% over the next five years. Our discounted cash flow (“DCF”) methodology incorporates a 9% cost of equity.

Net interest margins stabilize around 2.05% by fiscal 2026, reflecting loan repricing, increased competition, and higher wholesale funding costs. Banking fee income continues to decline, reflecting customer and public pressure on bank fees. Operating costs are well contained, a combination of reduced headcount and ongoing investment in IT capability, seeing the cost/income ratio improve to around 42% in fiscal 2028.

While we expect the bad-debt expense as a proportion of average loans to increase from the cycle bottom, in the absence of a severe and prolonged economic recession, recently tightened lending standards and low costs of debt make a return to historical averages unlikely over the medium term. The ratio peaked at 73 basis points in fiscal 2009 before dropping to 41 basis points in fiscal 2010 and 25 basis points in fiscal 2011. Return on equity reaches around 15% through to fiscal 2028.

For more on CBA and the big 4 banks: