You're going to hear a lot about Commonwealth Bank of Australia (ASX: CBA) today. Record profits. A strong balance sheet. A bigger dividend. It's disco time at CommBank, baby, and the party is in full swing.
But there's a hangover on the horizon for CommBank shareholders. China's economy is cooling and Australian unemployment is rising. Loan demand will follow suit and, even if real estate prices stay firm, future growth won't justify today's rich price tag of 2.6 times book value.
That Australia's growth is slowing makes it stupefying that investors are willing to pay a premium to CommBank's decade-long average price-to-book multiple of 2.3, a decade that piggybacked China's growth, the mining boom, soaring real estate prices, and featured zero recessions.
Not a Hater
It's not that I hate CommBank the business. It's great. I love that it has consistently grown products per customer, has a diverse sticky, revenue base that extends well beyond lending, and has an impregnable position in a consolidated market. I would gladly buy shares at the right price.
But no business is a buy at any price. And for me the "right" price for CommBank is more like below 1.8 times book value — a price more befitting a business with long-term returns on equity near 16% and that pays out 75% of its profits in dividends.
To be fair, CommBank isn't the only overvalued bank. Rivals ANZ (ASX: ANZ), Westpac (ASX: WBC), and National Australia Bank (ASX: NAB) all sell for rich premiums to book value despite posting extremely mediocre returns on assets — think 1% or lower. Mind you, Wells Fargo (NYSE: WFC) has posted a return on assets of 1.5% over the past year yet sells for only 1.5 times book value — a lower price tag that each of the other banks mentioned here.
Remember 3 Things
Don't forget.
1. Banks trade on earnings during good times and book value during bad times.
2. The price you pay for a business should be based on its future, not its past.
3. It's returns on assets that reflect a bank's underlying profitability, not returns on equity, which are a degree of separation away because of leverage.
Foolish Takeaway
Here's one more for the road: Dividend yields are only one part of the equation when it comes to whether you should own shares. And, big picture, the price you pay matters much more than a yield. The difference between a 6% yield and a 7% yield is nothing if you pay 40% more than a stock's fair value.
If you are craving yield, you need to look in a cheaper place. Consider The Motley Fool's favourite income idea for 2013-2014. It's featured in our brand-new, free research report, including a full investment analysis. Simply click here for your free copy of "The Motley Fool's Top Dividend Stock for 2013-2014."
More reading
- Commonwealth Bank profits set to surge
- Commonwealth will not offshore jobs
- Westpac behind on technology investments
Motley Fool advisor Joe Magyer owns shares and warrants of Wells Fargo. He has no position, long or short, in any of the other companies mentioned in this article.
