When it comes to Commonwealth Bank of Australia (ASX: CBA) shares, I'll look at the net interest margin, market share and price-book ratios. However, there are many — many — more ratios and metrics you could — and should — use to analyse bank shares.
The Net Interest Margin (NIM)
The net interest margin, sometimes shortened to 'NIM', is the difference between the interest rate a bank can lend its money versus what it must pay to get that money. For example, a mortgage might cost a homeowner 5% per year but the term deposits used to fund that mortgage pay away 4% per year. In this example, the net interest margin is 1%.
However, a net interest margin does not tell us anything overly meaningful by itself, so it's good to compare the current net interest margin to historical levels and that of its peers. Here are the net interest margins of the major Australian banks. I've used the latest official results I could find.
Net Interest Margins
As can be seen, the Net Interest Margin of CBA is slightly ahead of its local rivals, including Australia and New Zealand Banking Group (ASX: ANZ), Westpac Banking Corp (ASX: WBC) and National Australia Bank Ltd. (ASX: NAB). However, it also falls grossly short of those of its international rivals, like the USA's Wells Fargo and the UK's Barclays.
The net interest margins of Australia's banks have also fallen over recent years.
That means CBA's lending business has become less profitable. Closer inspection of the margin might suggest increases in the cost of funding, like term deposits and wholesale debt margins. Competition between banks is also a major issue. In Australia, many of the second or third-tier banks offer far better interest rates than the four major banks.
Market Share
Another way to analyse the banks is to look at market share. Thankfully, APRA, the bank regulator, demands to see the loan books of all Australian banks. It publishes the data each month. You can find it here.
Assessing market share enables an investor to understand where the bank makes its money. However, it can also do something more powerful. It can reveal which banks are experiencing growth.
Banking is competitive, so if one bank is growing quickly it must be doing something differently. Often, it means they are doing something shareholders will regret! For example, if your bank recently ramped up its lending to property investors — especially to apartment developers — it could have significant long-term implications.
Remember, bank loans are long-term commitments.
Once again, it's important to know how the data is calculated and how it has changed over time. The above graphs reveal CBA's share in just two markets — there are many other markets (think: credit cards, business lending, etc.). Nonetheless, it's clear CBA is a major player in its key markets of property lending. In recent years, it has experienced market share gains in these two areas.
The Price-Book ratio
Many people use the price-earnings ratio (P/E) to value bank shares.
Tsk. Tsk. Tsk.
Rookies.
The price-earnings ratio is simply net profit/share price.
However, banks nearly always trade at a lower P/E ratio compared to the broader market, so they nearly always look 'cheap'. However, among other things, banks are intensely cyclical. Their profits can appear enormous one minute only to be sliced and diced a year later, as bad debt charges leech profits.
If you are going to use any ratio to 'value' (if you can call it that) a bank share, use the price-to-book ratio (P/B ratio). It's calculated as share price/book value.
Above, I alluded to the concept that most banks make money from lending money at a slim margin.
Importantly, the 'book value' of a bank is much more stable than its 'profit', so it should provide a more reliable and stable reference point for your valuation. The book value is the value of assets (e.g. loans and credit cards) minus liabilities (e.g. term deposits and wholesale debt).
So what does CBA's P/B ratio tell us? It tells that investors 'value' its assets much more than any of its peers.
Bringing it all together
So, what do a falling net interest margin, growing market share and very large P/B ratio tell us? To me, that says CBA is less profitable but growing fast yet people (read: investors) are still willing to pay a premium valuation for its shares.
Hmm…mmm… a huh.
Of course, this is NOT a comprehensive picture of CBA.
Note: if you want me to do an in-depth piece on CBA, shoot me an email.
I should also make note of some of the other ratios and metrics I look for in a bank, such as:
- Cost to income
- Bad debts as a percentage of assets
- Provisions for bad debts
- Net interest income growth versus non-interest income growth
- Payout ratios
- Capital adequacy
- The types of loans being issued
Then, there are all the fun qualitative features I look for in a bank:
- Management
- Strategy
- Competitive pressures
- Cyclical effects
The list goes on.
Buy, Hold or Sell
Like I said, this is hardly a thorough analysis of CBA — it's a $140 billion bank! But I hope this provides an easy way to go about understanding the internal drivers of valuation and risks.
Oh, and, in summary, I'm in no rush to buy CBA shares. I own Wells Fargo shares (see my disclosure, below).
