Are the Biggest ASX Stocks Overvalued?

Are ASX stocks expensive?

One way to assess the price is via the spread between the risk-free rate (the rate investors can get on ultra-safe assets like government bonds) and the earnings yield on equities.

In Australia, the common proxy for the risk-free rate is the yield on 10-year government bonds.

Currently, the 10-year bond yield is 4.11%.

Given the ASX 200 has an earnings yield of 6.76%, the Aussie stock market’s equity risk premium is 2.65%.

Not much compensation for the added risk of investing in stocks as opposed to the nearly riskless government bonds.

Especially when you consider some research suggesting Australia’s historic market risk premium is around 5.1%:

In other words, Aussie stocks are expensive.

But can we measure this another way?

What if we took the biggest ASX stocks and valued them? Would our estimates of intrinsic worth overvalue or undervalue the companies?

Let’s find out.

Valuing the biggest stocks on the ASX

Let’s look at the three biggest stocks on the ASX 200 by market capitalisation and then value them using the Return on Equity (ROE) stock valuation formula.

This is not a very scientific approach…but I hope it will be fun and illustrative anyway.

Now, if you haven’t read Greg’s book or watched the recent What’s Not Priced In episode on stock valuation, here’s the ROE formula:

Currently, the three largest ASX companies by market cap are BHP, Commonwealth Bank, and CSL.

So, let’s see if the current prices the ASX’s biggest stocks trade at are justified.

Commonwealth Bank valuation

Let’s first turn to Commonwealth Bank of Australia [ASX:CBA].

Both Greg and I have estimated CBA’s intrinsic value in recent weeks.

Greg did so during the stock valuation special on What’s Not Priced In.

And I did it when demonstrating the usefulness of the dividend discount model.

Each time, our intrinsic value estimates showed the bank was overvalued.

This hasn’t changed in the weeks since.

On a FY24 forecast ROE of 13.2% and a payout ratio of ~75%, we get reinvested ROE of 3.3%.

Given a discount rate of 8%, CBA’s equity multiple comes in at 1.92. With a FY24 book value per share of $43.6, Commonwealth Bank’s estimated intrinsic value is $83.7.

Well below the bank’s current price of around $103 a share.

CBA is overvalued.

In a latest dispatch for The Insider,Greg said this means investing in CommBank at current prices yields plenty of risk for not much reward:

‘I mentioned last week that Commonwealth Bank of Australia [ASX:CBA]’s result would be an important one for the market. It wasn’t so much important as representative.

‘That is, the result was roughly in line with expectations…and while the stock rallied 2.5% over the week, at nearly 19-times FY24 forecast earnings, it’s hard to see how it has more upside from here.

‘Which is representative of the market in general. That is, earnings results (so far) are OK, but it’s all largely priced in. Which is why ‘the market’ managed just a 0.2% rise last week (despite the strong performance from CBA).

‘Buying CBA here isn’t going to help you outperform the market. CBA is the market, more or less. Buying it at 19-times earnings gets you a decent amount of risk for not much reward.

‘Paying 19-times earnings for a stock or a market, in general, represents an earnings yield of 5.2%. The Aussie 10-year bond yield, a proxy for the risk-free rate, is currently nearly 4.2%. That means the equity risk premium is a very thin 1%.

‘Again, there is not much reward for the risk of investing in equities.’

Progress report: one stock appraised, one stock overvalued.

CSL valuation

Let’s now move on to biotech giant CSL, who just released its FY23 results this morning.

FY23 revenue rose strongly, up 26%, to US$13.3 billion but net profit after tax fell 3% to US$2.19 billion.

CSL is a behemoth in its field, with entrenched competitive advantages.

But with the FY23 results now out, CSL is trading on a trailing P/E of nearly 40.

Is the multiple justified?

Let’s run the numbers.

CSL’s FY24 ROE is forecast at 17.4% on a payout ratio of 45%, meaning its reinvested ROE is 9.6%.

So, using an 8% discount rate, we get an equity multiple estimate of 3.59.

Given CSL’s FY24 book value per share is about $56.9, we get an intrinsic value estimate of $204.3 a share.

That implies the biotech giant is about 20% overvalued.

Progress report: two stocks appraised, two stocks overvalued.

Why the discrepancy?

I have a hunch it has something to do with CSL’s historic ROE figures. The market may be giving more weight to CSL’s past than its present.

If we use the Return on Invested Capital (ROIC) as a proxy, we can see that CSL’s profitability has been trending down in recent years:

BHP valuation

BHP is a special case and gave me plenty of trouble.

I went through a few looseleaf sheets rerunning the calculations as the results were bewildering.

Let me show you why.

BHP’s FY24 DPS is expected to be US$1.53 a share. Let’s assume a conservative payout ratio of 70%.

The mining giant’s FY24 ROE is forecast at a chunky 27%, meaning BHP’s reinvested ROE is ~8.1%.

Using a discount rate of 8%, we get an equity multiple estimate of 5.78.

On a forecasted FY24 book value per share of US$9.17, we get a crazy intrinsic value of US$53 a share.

At prevailing exchange rates, that’s around AU$82 a share, nearly a 100% premium to the current price…

What the #@$! is going on here?!

The ROE forecasts are too wacky.

According to historical data compiled by Market Index, BHP’s ROE over the last decade (beginning 2013) was 16.7%, 17%, 11.4%, 16%, 12.4%, 17.7%, 20.4%, 19.1%, 33.4%, and 47.5%.

Over this span, the miner’s ROE averaged 21.2%.

But the last few years are outliers.

A pandemic, disrupted supply chains, Russia’s invasion of Ukraine, and a surge in global inflation sent key commodities surging.

Just look at BHP’s FY22 return on capital employed (ROCE) for iron ore and coal:

In FY20, BHP’s group ROCE was 16.9%:

So, if we exclude the last two years, BHP’s average ROE drops to 16.3%.

Let’s bump that up to 17%.

Now we get an intrinsic value of US$26 a share, or AU$40.

That’s about 10% overvalued, given the current price.

Progress report: three stocks appraised, all three overvalued.

Where does value reside?

Clearly, this is not a very rigorous approach, but I hope it was informative nonetheless.

This exercise does suggest the top end of town offers little in the way of reward given the risk.

It seems value resides elsewhere.

Some, like my colleague Callum Newman, would say that place is small caps.

Others, like Brian Chu, would say it’s gold.

Gold, the contrarian asset

Brian Chu is Fat Tail’s gold expert.

You’d be hard-pressed to find someone more knowledgeable about gold than him.

After all, Brian runs his own family gold fund and has developed proprietary valuation methods to filter gold stocks.

When it comes to the yellow metal, Brian is the man.

And he’s about to lay out a new gold investing strategy to investors.

For Brian, the ideal time to invest in gold is upon us.

And he’s about to unveil how.

So stay tuned for details!

Regards,

Kiryll Prakapenka,
Editor, Money Morning