Why Commonwealth Bank is seriously overvalued

Commonwealth Bank (ASX: CBA) is trading at a record-high share price of over $132 per share.

That’s great if you’re in the stock. But what does it really mean? Is the underlying business firing? Or is the price representative of an overly optimistic market?

Let’s have a look at CBA through the lens of a rational investor buying the business, not the stock.

Rational investors understand that price and value are not the same thing.

Value is determined by discounting the free cash flows a business is expected to produce by an appropriate discount rate. Price is simply what the market decides to pay for the stock each day.

In the short term, price and value usually diverge. In the long term, they converge.

Because valuation inputs can vary widely, there is no such thing as one true business value. As Warren Buffett said, intrinsic value ‘is a number that is impossible to pinpoint but essential to estimate’.

All you can do is make realistic, rational assumptions, and go from there.

Another way to think about business value is to take the current price and work backwards. That is, work out what assumptions the market is implicitly pricing in to justify the current price. That way you can decide whether these assumptions are realistic…or nuts.

With that in mind, let's get stuck in…

Commonwealth Bank — price versus value

Over the past year, CBA’s share price is up nearly 35%.

Its market capitalisation (its ‘price’) has increased from $165 billion to $222 billion in the past 12 months.

That’s quite a move. What about the underlying business? Did it perform well enough to justify this rise?

Let’s look at the numbers. Forgive me for the detail. But it is necessary to see how the actual business has - and is expected to - perform.

Here are the actual (FY23) and forecast consensus earnings per share:

FY23: $5.84
FY24: $5.72
FY25: $5.68
FY26: $5.97

Return on equity (ROE) is a key profitability metric for banks. So let’s translate these earnings into ROE.

FY23: 14%
FY24: 13.4%
FY25: 12.8%
FY26: 13.2%

If these consensus estimates hold true, CBA will experience declining profitability from FY23-FY26.

And it’s not as if it’s growing its equity capital by a meaningful amount each year, which would make generating the same or a higher ROE challenging. CBA distributes most of its earnings as a dividend and only reinvests around 20% of earnings.

To give you an idea of what those reinvested earnings look like, equity per share was $43 at the end of FY23. At the end of FY26, it’s forecast to be $46 per share. That’s just 7% growth in per-share book value over three years or around 2.3% per year.

That’s not very ‘growthy’, is it?

The only way CBA can grow its business value (or intrinsic value) is if profitability (as measured by ROE) increases, or if it at least remains the same on a larger base of retained earnings.

But as you just saw, profitability is falling from its FY23 level. 

So why is the share price up nearly 35% in the past 12 months?

There are three possibilities:

1. Consensus estimates are too bearish 
2. Investors are willing to accept a lower long-term return from CBA, or 
3. A combination of the two

Let’s break these down…

To do that, we first need to estimate business value.

As Buffett said, this ‘is a number that is impossible to pinpoint but essential to estimate’.

So the below is just a ball park range.

For reference, I assume FY26’s profitability estimate (ROE of 13.2%) is sustainable. And I use a discount rate of 8%.

This gives a valuation range between around $81-$84 over the next few years.

With the share price well above these estimates of value, investors clearly expect CBA to be much more profitable.

How much more?

What is CBA’s share price saying?

I estimate the market is implicitly pricing an ROE of around 18.5%, 40% higher than consensus. The last time CBA generated that level of profitability was in 2014 when its asset base was 30% lower.

That seems like a very bullish estimate to me.

Maybe the discount rate, or expected rate of return, is too high? If current earnings estimates prove accurate, it appears that investors are willing to accept a much lower rate of return buying CBA at current levels.

How much lower?

I estimate that investors are implicitly discounting CBA’s cashflows by around 5.7%. Put another way, they’re accepting a long-term business return (dividends plus retained earnings) of 5.7% at these prices (Please note, for simplicity, I am ignoring the value of franking credits).

You can test this by looking at the numbers. CBA trades on an FY25 forecast yield of 3.47%. Retained earnings should increase by around 2.3% over FY25. That’s 5.77%, very close to my estimate.

The current share price could also reflect a combination of better-than-expected earnings and investors willing to accept a lower long-term rate of return.

Whatever the reason, the reality is this:

While CBA’s business performance has been sound, it has in no way justified the huge share price surge over the past 12 months. It’s all about ‘multiple expansion’.

That is, at the end of FY23, CBA traded on a price-to-book multiple of 2.33. It currently trades on a price-to-book multiple of 3.

That’s a nearly 30% increase due to multiple expansion, confirming CBA’s rise as being all about sentiment rather than business performance.

Over the long term, price and value converge

Banks are inherently risky. Accepting a long-term return only marginally above the risk-free rate as an equity investor isn’t sensible investing.

As I said, share price performance generally matches the performance of the underlying business over the long term. In the short term, it can do anything.

Over the past 12 months, CBA (and the other banks) have vastly outperformed their underlying business fundamentals.

They may continue to do this. Who knows? But in the long-term, CBA needs to increase profitability significantly. Otherwise, the price is likely to head back towards long-term business value.

In his 1990 Berkshire letter to investors, Warren Buffett explained his purchase of US bank Wells Fargo. He said it had been earning over 20% return on equity and 1.25% return on assets.

Berkshire purchased it for less than five times its earnings!

It wasn’t an easy task though. The share price fell 50% from when Berkshire first started buying. But this allowed Buffett to load up. It added to its position over the years and didn’t sell out completely until 2022.

What would Warren think of CBA today? An ROE of 13.2%...return on assets of 0.8%...and trading at 23 times earnings.

Hmmm…

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