Commonwealth Bank CBA has been dubbed the world’s most expensive bank by the AFR. The question is if that valuation is justified. CBA’s earnings highlight the quality of the wide-moat bank. A clear market leader with the lowest cost/income ratio, thanks to scale, cheaper funding costs, and leading digital offerings. Add to this low loss rates, a strong capital position, and strong track record of dividend growth.

But competition can't be ignored. Fiscal 2024 cash net profit after tax declined 2% as net interest margin, or NIM, slipped 8 basis points to 1.99%. This reflects industry headwinds from customer deposit price competition and switching, and discounting in home lending.

This was a bit better than our 1.97% forecast, and the 1-basis-point improvement on the first half supports our forecast for modest margin improvement over the medium term. Overall, the result was broadly in line with our expectations—flat top line with modest loan growth offsetting weaker margins, 3% expense growth, and below-average bad debt expenses.

What does one pay for a bank forecast to have earnings and dividends rise by 6% per year for the five years to fiscal 2029? A forward P/E of 21 times, dividend yield around 3.7%, and price/book of 3 times make the bank expensive, in our view. Our fair value estimate rises to $95 per share from $90 on the time value of money, still materially below the current share price.

Debate on what supports the bank share price rages on, including buyer support from passive funds, interest from global investors, to active managers reducing underweight positions. And with retail shareholders on large capital gains, sellers aren’t rushing to meet this demand for shares.

The fully franked final dividend of $2.50 takes full-year dividend to $4.65. A 3.3% increase on last year and modest beat on our $4.60 forecast. And we do believe that CBA has the best dividend prospects for the big-4 banks. Our forecasts assume a dividend payout ratio close to 80% over the medium term, the top end of management's 70%-80% target range. The capital position is strong. Only $282 million of the bank's $1 billion on-market buyback is complete.

Business strategy and outlook

Commonwealth Bank of Australia is the largest of Australia's four highly profitable, wide-moat-rated major banks. It offers a full suite of banking services in Australia and New Zealand. In the long run, the bank has consistently increased shareholder wealth in favorable economic times. The loan book's large weighting to home loans and the high proportion of customer deposits reduces risk on bad debts and sudden changes to funding costs.

While Australian housing is expensive and debt/household income ratios are high, we remain comfortable for several reasons. Tight underwriting standards, lender's mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, and a high proportion of variable rate home loans combine to mitigate potential losses from mortgage lending.

With cash rate increases to combat high inflation being swift and large, the risk of higher credit losses has increased materially. It also reduced demand for credit. We expect modest credit growth and margins improvement in fiscal 2025. Operating expenses will continue to rise due to inflationary pressure and the bank investing to capture growth opportunities, this despite productivity improvements being realized.

Bad and doubtful debts expense peaked in first-half fiscal 2009. Elevated loan losses in fiscal 2020 were entirely due to loan loss provisions. With large provision balances, and economic conditions improving, loan losses are expected to be moderate in the short term.

A string of divestments plus strong organic capital generation see the bank retain a strong capital position even after completing share buybacks.

CBA bull say

  • Commonwealth Bank of Australia's well-managed net interest margins, sound asset quality, and strong balance sheet continue to consistently deliver solid financial results.
  • Costs have been increasing due to compliance, regulatory and prudential issues, but longer term, we expect tighter control to support earnings.
  • Strong organic capital generation leave the bank well placed to make market share gains while still paying attractive dividends to shareholders.

CBA bears say

  • Increased regulatory, political and public scrutiny could erode the bank’s pricing power and over time, its wide economic moat.
  • Commonwealth Bank is a major beneficiary of transaction account funding, and competitors paying much higher rates could encourage more customer switching and increase the average cost of funds.
  • Slow GDP growth and highly indebted households could see credit growth slow further.

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