5 reasons why Commonwealth Bank is overvalued

With this stock, the risk/reward ratio is tilted heavily to risk.

a woman

The popular perception that bank shares are a safe investment depends purely on the price paid for them. Buy too high and the risk of capital loss is also high, a point made by several writers in this space.

Today, let’s a look at some of the risks facing Commonwealth Bank (ASX: CBA), although it is by no means alone.

1. Excessive housing exposure

On comparative criteria, Australian median capital city residential prices are the most overvalued in the world. A recent concern is the reported frantic surge in ‘investment’ buying – further crowding out the genuine home purchaser looking for something affordable. This situation is neither economically or politically sustainable.

Commonwealth has a mammoth 25.3% share of the housing mortgage market, making it especially vulnerable to the inevitable change in the interest rate cycle and subsequent likely dislocation of the housing market. Another concern is the Commonwealth Bank’s increasing tendency to source new housing loans through mortgage brokers, reducing margins.

2. Poor price-to-book ratio

As an investment measure, one quick way of assessing banks is the price-to-book ratio. Generally, a low ratio indicates a stronger margin of safety. For example, major US banks have an average ratio of 1.2 as do those in the UK. In Australia, ANZ’s (ASX: ANZ) ratio is 1.9, NAB’s (ASX: NAB) is also 1.9 and Westpac’s (ASX: WBC) is 2.2. Commonwealth Bank has a price-to-book ratio of 2.7 — on comparative terms one of the highest in the world.

3. Unsustainable return on equity

Commonwealth has a high return on equity (18%), partly reflecting a high exposure to the lucrative residential housing market (banks are able to leverage housing loans much more than commercial loans). Normally a high return on equity can be seen as a good thing; however this doesn’t necessarily apply to highly leveraged financials such as banks. It can equally indicate a poorly balanced loan portfolio, excessive reliance on external funding or that the housing party is almost over. The Reserve Bank, APRA and the IMF have all expressed concern over the high proportion of housing loans held by the Australian banking industry, and the Commonwealth Bank takes the cake here.

4. Insufficient deposit funding

History indicates that a stable retail bank is one where deposits at least equal loans. In Commonwealth Bank’s case, deposit funding only provides 63% of loans — 37% is raised by other means. Too much reliance on other funding sources can quickly lead to trouble should economic conditions deteriorate. With a 1.1% return on assets there isn’t all that much room to move.

5. Increasing competition

Commonwealth faces increasing competition for new loan growth as other banks and smaller financiers begin to respond aggressively. With more profitable older loans tending to be paid down there is a pincer movement developing and the effects will be felt by all retail banks.

Foolish takeaway

It can be argued the major retail banks are good investments because they are safe investments, protected by government policies, attractive yields and their dominance of the Aussie share market. However these factors alone don’t merit a high investment premium – future outlook and value determine that. I expect Commonwealth Bank will struggle to produce significant growth in earnings and dividends over the medium term, and is a sell.

Discover The Motley Fool’s favourite income idea for 2013-2014 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

Motley Fool contributor Peter Andersen doesn’t own shares in any company mentioned in this article.

Wondering where you should invest $1,000 right now?

When investing expert Scott Phillips has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for over ten years has provided thousands of paying members with stock picks that have doubled, tripled or even more.*

Scott just revealed what he believes could be the five best ASX stocks for investors to buy right now. These stocks are trading at near dirt-cheap prices and Scott thinks they could be great buys right now.

*Returns as of January 12th 2022

More on ⏸️ Investing

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

asx share price competitions represented by businessmen arm wrestling
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »

person reading news on mobile phone
⏸️ Investing

Why Fox (NASDAQ:FOX) might hurt News Corp (ASX:NWS) shareholders

News Corporation (ASX: NWS) might be facing some existential threats from its American cousins over the riots on 6 January

Read more »