Is the market too optimistic on CBA shares?

CBA shares seem to have a sky-high valuation. Has it gone too far?

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The Commonwealth Bank of Australia (ASX: CBA) share price has gone on an incredible run in 2024, rising by approximately 25%. Considering the S&P/ASX 200 Index (ASX: XJO) has only risen by 7.7% this year, the ASX bank share's rise has been extraordinary.

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Some understandable factors may have contributed to CBA's rise, including substantial institutional (like super funds) and passive index fund money (such as Vanguard) looking for a home on the ASX share market. A rotation out of ASX mining shares and into ASX bank shares may also have been a factor.

Regardless of the reason, the CBA share price is now sitting at a high price-earnings (P/E) ratio. It's worth questioning if the valuation has gone too far.

Does the valuation match the earnings growth outlook?

When a share price rises, it normally means investors expect that business to make more profit in the future. If the valuation jumps significantly, it suggests the market is significantly more optimistic about the situation.

Did the most recent report justify that rise?

In FY24, the company reported that its cash net profit fell 2.3% to $9.8 billion, with cash earnings per share (EPS) of $5.88. That means the current CBA share price is trading at 24x FY24's earnings.

Falling profit does not justify a higher share price, in my mind.

However, if CBA's profit can rise significantly from here, then it could justify the valuation.

Analysts are expecting the ASX bank share to report pre-provision profit growth again in the first quarter of FY25, which is due to be released on 13 November 2024.

According to reporting by The Australian, Morgan Stanley is expecting pre-provision profits to be "growing again", but the broker is also focused on the profit margin and lending volume growth. Commentary on loans and deposits competition could also be insightful.

Morgan Stanley is forecasting that CBA's pre-provision profit would be up 6% on the quarterly average from FY24, with 4.5% revenue growth and 2.5% expense growth in the FY25 first quarter.

The broker is expecting CBA to report loan growth at 1.2x faster than the overall loan system, while volume growth is expected to be 1x (the same growth rate) as the overall system.

However, Morgan Stanley warned that CBA's credit quality is expected to decrease in the FY25 first quarter, with an increase in troublesome and impaired assets to around $9 billion and a rise in mortgage arrears to 70 basis points (0.70%), according to The Australian.

My take on the CBA share price

It's good to know that CBA is expected to see profit growth return, but rising arrears certainly isn't a good sign for the rest of FY25.

Personally, I wouldn't want to invest in CBA shares at a P/E ratio above 20 if underlying profit is only growing at a low-to-mid-single-digit rate.

Competition in the banking sector remains strong. I don't expect bank margins to recover to their former heights several years ago. I think competition and the strong market position of brokers mean banks like CBA may find it harder to grow at a pleasing pace in the longer term.

CBA is a great bank, and I'd be happy if I were a long-term shareholder. However, I wouldn't choose to buy new CBA shares at the current price. I think the market has sent the CBA share price too high.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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