in Australasia, Australian Economy, Featured, Financial Markets, Iron Ore /
As far as we’re concerned, the most interesting thing to happen this week is the fact that the Commonwealth Bank (CBA) now has a market capitalisation equal to that of BHP. Or at least we thought it did after glancing at this article. Which just goes to show you shouldn’t believe everything you read.
Because BHP is dual listed (in London and Sydney) it has two separate market caps that combine to produce a total capitalisation of around $190 billion (around $115 billion in Sydney and $75 billion in London). CBA on the other hand has a market capitalisation of around $113 billion.
Although we can’t find the article now, we did read a few weeks ago that CBA’s market cap is larger than the combined capitalisation of all the banks in Germany. If it’s true it’s another warning sign to go with Murray’s far more scientific signal.
We like crazy warning signs like this. It’s the sort of thing you can look back on in years and laugh about. Like, ‘Yeah, can you believe the Commonwealth Bank was once worth more than all of Germany’s listed banks combined?’
Even though the market values the two companies only slightly differently now (see below), it values CBA much higher, and BHP much lower, than it did a few years ago.
That’s interesting in itself. Both companies benefitted from China’s growth, although BHP received the benefit first and CBA later as the proceeds from Australia’s raw materials sales flowed through into higher national incomes and a continuing demand for debt.
At the heart of this ‘benefit’ is iron ore…a bubble which popped in 2011/12, reinflated in late 2012, and is currently giving off ominous hissing sounds. The market knows this, which is why it has marked down the value of BHP and other iron ore miners recently.
But it doesn’t see any link to the banks. While BHP trades around $36, well below its high of $50 reached in 2008 and 2011, CBA is at record highs around $70.
Is it justified? Let’s do some comparing…
BHP mines raw materials from around the globe. It focuses on mining very large, low cost deposits of iron ore, coal, oil, gas, copper, and to a lesser extent nickel and aluminium. It’s capital intensive and its profitability (which is basically the productiveness of its capital) is dependent on the vagaries of global commodity prices.
The CBA mines ‘customers’. Its aim is to provide services to those customers, either by providing debt, insurance or investment management. The CBA is also a highly capital intensive business, but it relies on a leveraged balance sheet to generate returns to shareholders (the providers of ‘equity’ capital).
On 31 December, 2012, BHP had equity capital of US$67 billion. According to consensus forecasts for 2013, the company should generate a profit of US$14.1 billion on that equity. A simplistic calculation of BHP’s return on equity then, is about 21%.
That’s a pretty decent return for such a large company. It’s why the market values BHP’s equity at a premium. That is, the market value of $190 billion (or about US$186 billion) is 2.78 times the value of shareholder equity. In other words, BHP trades at 2.78x ‘book value’.
Turning to the CBA, it had $42.8 billion in shareholder equity at 31 December. According to estimates, it should generate a profit of $7.37 billion in 2013, for a 17.2% return on equity. Although not as high as BHP’s, that’s a decent level of profitability too. Because of this the market values CBA at 2.64x book value.
So, breaking it down, the market values BHP at 2.78x equity value because it generates a strong return on that equity of 21%. It values CBA at 2.64x equity based on its return of 17.2%.
Does that tell us anything? Well, simplistically, it says that by buying at current prices and assuming forecast rates of profitability, the implied return you’re getting from BHP and CBA is 7.55% (21/2.78) and 6.52% (17.2/2.64) respectively.
In other words, BHP is cheaper than CBA. But it doesn’t take into account franking credits and as you know, one of the reasons the banks are in favour is because of their dividends and franking credits.
Adjusting for that, there’s probably not much difference between the two companies from a valuation perspective. That is, they’re as equally as expensive as each other. The implied return is poor based on the risks, and it assumes high rates of profitability that we don’t think will persist into the future.
Both companies have played the China card, and both have done well. But that is in the past. We think a far more turbulent future for the Middle Kingdom awaits. And because of this, we would ask for much higher ‘implied returns’ to compensate for that risk. Right now the market doesn’t agree. But when it does, you’ll see much lower share prices.
for The Daily Reckoning Australia
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