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.

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

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