Here’s why everyone loves the Commonwealth Bank of Australia

The Commonwealth Bank of Australia (ASX: CBA) is Australia’s largest bank. It’s capitalised at over $120 billion and services Australian and New Zealand banking and insurance customers, as well as consumers in select Asian and Pacific countries.

Compared to its peers, Commonwealth Bank trades on a higher price to earnings ratio (PER) and lower dividend yield. But what makes the Commonwealth Bank the favourite for many investors among the big banks? Why does it command a price premium and dividend discount to its peers?

Some say it’s to do with the stability of the company’s earnings, heavy weighting towards consumer home loans, and high proportion of consumer deposits as a funding source. While I have no doubt that these are contributors, I think there’s more to it.

It has the highest return on equity (ROE)

Over the past nine years, CBA’s ROE has only once dipped below 15%, and has averaged close to 17%. This is above the average of peers Australia and New Zealand Banking Group (ASX: ANZ) at 13.5%, National Australia Bank Ltd (ASX: NAB) at 12.5%, and Westpac Banking Corp (ASX: WBC) at 15.5%. This means that for every dollar of shareholder equity in the business, it’s generating 17 cents of profit. Compounded over many years, it has made a huge difference to long-term shareholders.

Strong earnings outlook

Analysts are predicting earnings growth of up to 10% for financial year 2014. The company is on track for an 8% rise based on the first-half figures released in February, however they could surprise to the upside if home loan growth numbers continue to show sustained investor and homeowner activity.

Additionally, while some are concerned about a property bubble and the resulting rise in bad debts for the big banks, loan structures in Australia should limit broad-based declines due to high underwriting standards, full recourse lending, lenders’ mortgage insurance and comparatively high interest rates.

Strong balance sheet and incredible management

Finally, under the stewardship of Ian Narev, CBA has managed to increase net profit from just over $7 billion in 2012, to an estimated $8.5 billion this year and $9.3 billion next year. This incredible growth has come at a time when the Australian economy has been performing below par, requiring management to focus on cost-cutting and efficiency improvements.

They have been successful, as we saw in the past half-year results, when the company recorded a 13% jump in net profit, but only a 1.7% rise in costs on an underlying basis.

The company also fully complies with the Basel regulations of bank capital requirements, and opted against neutralising its share purchase plan in the last half to boost tier 1 capital in order to meet 2016 standards.

Foolish takeaway

My belief is that CBA commands a premium to its peers primarily because it’s regarded as the ‘best and safest’ option. In fact, CBA’s balance sheet strength and conservative portfolio is so well managed that even during the GFC, earnings per share and dividend fell only 14%. CBA is one of Australia’s most recognised and trusted brands and has the physical store presence and marketing budget to continue commanding the lion’s share of the home loan market.

CBA is also investing in a new IT system, which should improve customer experience and ideally ROE over the long term too.

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Motley Fool contributor Andrew Mudie does not own shares in any companies mentioned

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