Should you sell Commonwealth Bank?

Why this market darling could be setting investors up for heartache.

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Commonwealth Bank (ASX: CBA) is a banking juggernaut – but is it a good buy today? I ran the stock through my seven big questions to help judge whether the stock deserves Fools’ dollars.

1. What are the company’s competitive advantages, and how durable are they?

Commonwealth has strong competitive advantages: A sticky customer base, a strong and widely known brand, massive scale that allows it to spread costs, and a dense network of branches. Those advantages look pretty durable given the lax competition between the big four banks.

2. Why is this stock interesting now?

No obvious reason springs to mind. The stock has soared 45% over the past year to a new all-time high.

3. What is our variant perception?

Commonwealth is one of the biggest and most widely studied businesses in the S&P/ASX 200 (ASX: XJO) (Index: ^AXJO), so good luck spotting something the rest of the market hasn’t. Buying Commonwealth amounts to a vote for the status quo, which could be risky considering the stock’s lofty valuation (see below). You’ll have an easier time unearthing hidden gems by looking at smaller companies that most analysts don’t have the time to research.

4. Can the business earn high rates of return on the marginal dollar it reinvests?

Doesn’t look like it. That the company pays out more than 50% of its profits in dividends says a great deal. True, Commonwealth has posted returns on equity in the high teens over the past several years but that probably says as much about the strength of the overall Australian economy as it does company’s reinvestment prospects.

5. Do we trust management with shareholders’ cash?

It’s hard to complain about a record share price and $4 billion in dividends paid in 2012. Book value per share has grown at almost 7% annualised over the past five years despite the bank’s high payout ratio, which is impressive.

6. Do management’s incentives align with minority shareholders?

Yes. CEO Ian Narev owns gobs of Commonwealth shares. Still, I’d rather see a higher mix of compensation tilted towards long-term incentives.

7. Are the shares attractively priced?

Not at first blush. Today’s asking price of 2.6 times book looks classically expensive. The shares have sold for an average of “only” 2.3 times book over the past decade. That seems pricey for a bank that consistently delivers returns on assets of only 1%. Meanwhile, fellow banking biggie Westpac (ASX: WBC) sells for 2.2 times book and comparable American mega-bank Wells Fargo (NYSE: WFC) sells for only 1.3 times book value despite posting a superior 1.3% return on assets over the past decade.

The current valuation only makes sense if Commonwealth can continue posting returns on equity near 18% as it has done over the past three years. That’ll require a continued strong economy and lots of leverage. An economic rough patch could send returns on equity spiraling into the low teens or single digits, though, as happened a decade ago and in the late 1990’s, which would yank the multiple Mr. Market is willing to pay for the shares down to the neighbourhood of 1.2-1.5 times book value. Buyer beware.

So is Commonwealth a buy?

Not today. In fact, it’s hard to make a case to own it at all.

Commonwealth has some powerful advantages but today’s stock price bakes in an expectation that the good times will always last. They won’t. The best time to buy banks is during recessions when profits are low and the multiple the market is willing to pay follows suit. Fools can afford to be greedy and look for cheaper, less obvious stocks.

Commonwealth does have one big thing going for it, though: a fully-franked 4.5% dividend yield. That chubby yield will act as a cushion if the stock price falls. Commonwealth isn’t the only dividend game in town, though. Get “3 Stocks for the Great Dividend Boom” in our special free report. Click here now to find out the names, stock symbols, and full research for our three favourite income ideas, all completely free!

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The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Motley Fool investment analyst Joe Magyer owns Wells Fargo warrants.

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