Equity Strategy
20 March 2024
Banks: Valuations Overheated
Australian Banks are Expensive

Bank stocks have rallied over the last 3-4 months.

The recent bank stock rally looks overdone. Valuation multiples have risen significantly, and are now stretched relative to historical norms. Current valuations are disconnected from fundamentals, given the tepid (+2%) earnings growth expected over the next 2 years.

The recent rerating appears to be predicated on the market's anticipation of upward revisions to earnings estimates over the next 12-24 months. However, our analysis of historical trends and current consensus estimates suggests limited upside to forward earnings, even with the possibility of a soft landing and interest rate cuts in the next 12-18 months.


Portfolio Changes

Trimming Westpac (WBC) -2%

Increasing BHP (BHP) +2%


Considering current valuations are above pre-GFC highs and with only modest earnings upside risk, we have reduced our exposure to the banks by reducing our exposure to Westpac (WBC) by 2%. This takes us underweight the stock and even further underweight the sector (Focus Portfolio 13.5% vs ASX 300 21%).

We have increased our allocation to BHP by 2% to a weight of 10%. This reduces our underweight position in the iron ore miners (BHP, RIO, FMG), which currently represent 12.7% of the ASX 300 after a period of YTD underperformance, driven by lower iron ore prices. BHP's underappreciated copper assets keep the stock attractive at these levels.

Figure 1: Current valuations are disconnected from fundamentals
Company Name Ticker Forecast Multiples EPS
Dividend Yield % ROE EPS Rev 90 days
12mth fwd PE PE Premium vs 20yr Average (FY1-FY3) 12mth fwd (NTM)
CBA CBA 20.7 45.3% 1.0% 3.9% 12.8% -0.4%
NAB NAB 15.2 24.6% 3.2% 4.9% 11.3% 1.3%
Westpac WBC 14.2 16.3% 2.6% 5.5% 8.9% 1.6%
ANZ ANZ 13.0 11.6% 2.5% 5.7% 9.6% 2.8%

Source: Refinitiv, Wilsons Advisory. 


Valuations are Stretched

A key concern on the banks is their elevated valuations, with PE multiples above pre-GFC levels.

While price-to-book ratios indicate less inflated valuations. We note that the returns profiles of the banks have changed significantly over the last 20 years. Over the past 2 decades, the return on equity (ROE) of major banks has declined substantially, largely explaining the decrease in the price-to-book ratios.

Against global peers the Australian banks look expensive. While CBA has a lower ROE (13.3%) relative to JP Morgan (JPM) (14.9%), it trades on a 58% premium on a price-to-book basis. While the historically resilient Australian economy and the concentrated nature of the domestic banking sector deserves a premium, this is excessive. It is a similar story for the other big 4 banks relative to global peers.

Figure 2: Bank sector PE is elevated vs history
Figure 3: Banks’ PE relative to the market is also elevated vs history
Figure 4: Banks are attractive on a price to book basis; however, not when considering the declining returns on equity
Figure 5: The big 4 banks are expensive vs global peers

What is priced in?

The current valuations suggest the market is expecting earnings upgrades. At the current PE multiple of 16.2x, our estimates suggest the market anticipates earnings upgrades of ~28% for the banks to trade at the 20-year historical average PE (12.7x) and ~14% at 1 standard deviation above the average (14.3x).

CBA's premium valuation, currently trading at a 45% premium to its 20-year average, is a significant contributor to the overall sector premium. However, the elevated valuations extend beyond CBA. NAB, WBC, and ANZ all exhibit pricing disconnects from their historical averages, with premiums of 25%, 16%, and 12% respectively. While the magnitude of the disconnect is less extreme than CBA, it suggests a broader sector-wide phenomenon.

Is the market right?

Historically, when banks have traded at multiples above their 20-year average PE ratio (12.7x) they have unperformed the broader market. On average, such periods have resulted in a subsequent -2.9% relative annual return. This demonstrates the sector’s potential for overvaluation and the historic tendency for there to be a disconnect between market expectations for earnings upgrades and their ultimate realisation.

An analysis of the key levers for potential earnings revisions (credit growth, bad debts, and NIMs) suggests the magnitude of upgrades priced in by the market will be challenging to achieve.


Credit Growth – Soft Landing Scenario is Supportive of Trend Growth

While consensus estimates for system credit growth over the next few years are plausible, the potential for substantial upgrades is relatively limited. According to consensus forecasts, the big 4 banks are poised to deliver solid, albeit ‘trend’, credit growth of ~4-5% p.a. between FY24-FY26. This is broadly in line with our base case expectations.

However, the rally in the banks since late 2023 suggests the market is positioned for further upgrades to credit growth expectations, which has been driven by the rising consensus of a ‘soft landing’ for the domestic economy. Significant upgrades to credit growth expectations are not in our base case, and would likely require a more aggressive than anticipated interest rate easing cycle from the RBA (with futures currently implying 0.635% of cuts by Aug 2025).

The last period of prolonged above-trend credit growth was between FY13-FY15. This occurred amidst a combination of successive RBA rate cuts of ~1.5% (from 3.5% to 2%), strong house price growth, and generally buoyant household and business confidence. Credit growth ultimately slowed after APRA introduced a series of macroprudential policies to prevent excessive credit growth, which included loan growth limits (2014) and interest-only loan restrictions (2017).

A repeat of the strong growth seen in FY13-FY15 is unlikely to be repeated this cycle.


Credit Growth Verdict – Small Upside Risk

Over the medium-term, more or less ‘trend’ credit growth is likely to be supported by a relatively modest RBA easing cycle and a sound economic backdrop. But we note this is already largely reflected in consensus with limited risk to the upside, in our view, barring a significant shift in the economic environment. Moreover, in recent years APRA has demonstrated its ability to intervene as required to manage credit growth and financial stability, which arguably puts a soft ceiling on credit growth relative to history.


NIMs – Still Structurally Challenged

Net interest margins (NIMs) are structurally challenged with mortgage lending competition remaining intense, driving down rates offered to borrowers. This competition is unlikely to falter with Macquarie becoming the fifth new big player. This puts structural pressure on the banks' ability to maintain margins within their core businesses.  

Australian banks are grappling with a two-pronged challenge in the deposit market. Increased competition from new entrants and fintech firms is pressuring them to offer competitive rates to retain their customer base. Furthermore, a mix shift in deposits presents an additional hurdle.

Figure 6: Consensus credit growth is inline with our basecase

A declining rate environment can challenge margins – this time is likely to be no different

While potential cuts to the official cash rate by the Reserve Bank of Australia (RBA) could lead to slightly less competition for deposits, it's unlikely to be a significant benefit for margins. This is because:

Government/regulatory scrutiny - With high government scrutiny on the banking sector (like we have seen in the supermarkets) amidst the ‘cost of living crisis’, banks will be likely to pass on a significant portion of any rate cuts to borrowers, further squeezing margins.

Rate cuts and NIMs - Historically, lower interest rates have generally led to lower NIMs for Australian banks. Even if competition eases slightly, the overall decrease in interest rates may not be enough to offset the decline in margins.


NIMs Verdict – Downside Risk

NIMs pose a downside risk to earnings. Competition remains heightened, while rate cuts can be a headwind for margins, especially with scrutiny from the government/regulator. Margin downside could offset any upside in credit growth.


Bad Debts – How Much Will They Rebound?

Across the big 4 banks, asset quality measures have been significantly more benign than the market has expected and credit losses have surprised to the upside as a result, which has supported bank earnings forecasts to date. 

While the banks have so far reported limited signs of stress, helped by a resilient economy, there is little debate that bad and doubtful debt (BDD) expenses will rise from here given both the low base and the still percolating impact of higher interest rates (and dwindling savings buffers) on household balance sheets.

According to consensus forecasts, non-performing loans (NPLs) are set to increase meaningfully over the medium-term to just under 1% of total gross loans on average across the big 4 banks, which is above the 10-year average trend.

Figure 7: NIMs have been in structural decline for 30 years
Figure 8: Bad debts consensus expectations are not unreasonable, with limited upside risks to earnings

Bad Debts Verdict – Upside Insufficient to Justify Current Valuations

A meaningful increase in bad debt expenses is consistent with our base case, although consensus forecasts are still seemingly taking a conservative stance towards asset quality measures for the Big 4, suggesting there is upgrade potential on the bad debts front (i.e. potential for BDDs to be lower than currently expected) with a soft landing.

However, bad debt upgrades alone will not be enough to support this rally. For instance, looking at WBC, the bank with the lowest credit quality of the big 4, even a 50% reduction in its bad debt expense would only drive a relatively modest ~6% increase in its NPAT. This extreme hypothetical scenario is firstly very unlikely, but secondly, it would not reduce WBC’s PE ratio (via a higher ‘E’) enough to make the banks reasonably priced.


Overall Verdict – Upside Potential Falls Well Short of Justifying Current Valuations

While potential improvements in credit growth and a reduction in bad debts offer some upside, the magnitude is unlikely to be sufficient to justify the level of earnings upgrades currently priced into the market. The recent rally appears to be overdone, and achieving the market's lofty expectations is unlikely. This challenge is further compounded by persistent competition within the sector and the ongoing downward pressure on net interest margins (NIMs).


Trimming Westpac (WBC) -2%

Following a period of strong performance, we have reduced our weighting in WBC. This decision is based on several factors:

ROE: WBC exhibits the lowest return on equity among the big four banks, making it potentially less attractive.

Cost pressures: Persistent cost issues raise concerns about future profitability, with the upcoming results potentially revealing further negative surprises.

Strategic Positioning: We favour lenders with a diversified business model, reducing exposure to the highly competitive mortgage space. CBA and WBC have a significant exposure to mortgages, which is more susceptible to further margin compression.

Potential leadership change: The possibility of a near-term CEO departure adds uncertainty and could hinder performance.

Expensive: As discussed above, WBC is expensive vs history and relative to its forecast earnings growth (even with upgrade). This is a key reason for trimming the position.


Increasing BHP (BHP) +2%

Following a period of underperformance, we have increased our position in BHP to 10%, narrowing our underweight to the iron ore sector, which represents ~13% of the ASX 300. This decision was made considering:

Neutralizing sector underweight following a period of weak performance the iron ore sector has underperformed in recent months as spot prices have weakened after a period of surprising resilience in the face of a relatively benign structural and cyclical backdrop. The iron ore price has now retreated from its January 2024 peak of US$145/t to currently around ~US$100/t, while consensus medium-term price assumptions are now sitting in the ‘mid US$70s’. As iron ore prices (and consensus expectations) have normalized to be broadly in line with their long-term average and closer to our assessment of ‘fair value’, the recent pullback in the iron ore miners presents a good opportunity to lighten our sector underweight by adding to BHP. 

Underappreciated copper exposure BHP has the world’s largest copper endowment across a portfolio of high quality, low cost, long life assets. Consensus expectations are for copper to account for ~40% of group EBITDA by FY26, and by the end of this decade we expect BHP’s copper earnings to surpass its WA iron ore earnings. This ‘future facing’ tilt is still underappreciated by the market and is a key source of relative appeal for BHP vs the other majors, given we are structurally bullish towards copper with the energy transition set to underpin growing supply deficits, likely supporting higher long-term copper prices. Taking a near-term view, with the copper price rallying to 12-month highs, there is upgrade potential for BHP’s copper earnings, noting the consensus FY25e copper price of US$3.98/lb sits below the current spot price of US$4.13/lb. 

Figure 9: Copper price has recently rallied; we remain structurally bullish copper. Iron ore price is normalising to lower levels
  • Share This Article

Written by

Rob Crookston, Equity Strategist

Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.

Disclaimer and Disclosures

About Wilsons: Wilsons is a financial advisory firm focused on delivering strategic and investment advice for people with ambition – whether they be a private investor, corporate, fund manager or global institution. Its client-first, whole of firm approach allows Wilsons to partner with clients for the long-term and provide the wide range of financial and advisory services they may require throughout their financial future. Wilsons is staff-owned and has offices across Australia.

Disclaimer: This communication has been prepared by Wilsons Advisory and Stockbroking Limited (ACN 010 529 665; AFSL 238375) and/or Wilsons Corporate Finance Limited (ACN 057 547 323; AFSL 238383) (collectively “Wilsons”). It is being supplied to you solely for your information and no action should be taken on the basis of or in reliance on this communication. To the extent that any information prepared by Wilsons contains a financial product advice, it is general advice only and has been prepared by Wilsons without reference to your objectives, financial situation or needs. You should consider the appropriateness of the advice in light of your own objectives, financial situation and needs before following or relying on the advice. You should also obtain a copy of, and consider, any relevant disclosure document before making any decision to acquire or dispose of a financial product. Wilsons’ Financial Services Guide is available at wilsonsadvisory.com.au/disclosures.

All investments carry risk. Different investment strategies can carry different levels of risk, depending on the assets that make up that strategy. The value of investments and the level of returns will vary. Future returns may differ from past returns and past performance is not a reliable guide to future performance. On that basis, any advice should not be relied on to make any investment decisions without first consulting with your financial adviser. If you do not currently have an adviser, please contact us and we would be happy to connect you with a Wilsons representative.

To the extent that any specific documents or products are referred to, please also ensure that you obtain the relevant disclosure documents such as Product Disclosure Statement(s), Prospectus(es) and Investment Program(s) before considering any related investments.

Wilsons and their associates may have received and may continue to receive fees from any company or companies referred to in this communication (the “Companies”) in relation to corporate advisory, underwriting or other professional investment services. Please see relevant Wilsons’ disclosures at www.wilsonsadvisory.com.au/disclosures.

Related articles