When Commonwealth Bank reports its full-year results, many fund managers will be looking for evidence that its extraordinary valuation can’t last. They may be disappointed.
CBA is probably the most controversial and confusing share on the ASX. It trades at a much higher earnings multiple than the other major banks. It’s also among the most expensive developed market banks globally.
Fourteen of the 16 analysts covering CBA rate it either a sell or underweight. Not one recommends buying it, and yet its share price remains stubbornly high.
When this happens, index funds often get the blame. The argument is that passive investors are mindlessly buying CBA because it is Australia’s largest listed company. As its price rises, its index weight increases. That supposedly forces index funds to buy more and creates a self-reinforcing bubble.
How index funds work
It’s a neat explanation but it’s also mostly wrong. Index funds don’t decide what CBA is worth, they simply follow prices already being set by the market.
If CBA’s price rises relative to other companies, its index weight increases automatically. An index fund or ETF doesn’t usually need to buy more CBA when this happens because the shares it already owns have increased in value by the same amount.
New money flowing into index funds will lead to some CBA buying. However, that money is spread across the market according to existing index weights. It doesn’t automatically make CBA more expensive relative to every other company.
Most importantly, ownership isn’t the same as price discovery. Research in larger overseas markets suggests index funds account for only a small share of the trading that sets daily prices. There’s little reason to believe they’ve displaced active investors as the main source of determining CBA’s share price. It is active investors, hedge funds and traders that are still setting prices at the margin.
We saw this after CBA’s trading update in May. Its shares fell 10 per cent in a day because investors reassessed the outlook and were prepared to sell at lower prices. Index funds didn’t take the day off, they simply followed the market down in the same way they’d followed it up.
Blaming index funds for CBA’s valuation is a bit like blaming the scoreboard when your team is losing. In fact, active fund managers may be doing more to support CBA’s share price than passive investors. Many active managers have remained underweight CBA because they believe it’s overvalued. As the shares have continued rising, their returns have fallen further behind the index.
Active fund managers scramble
Some super funds are reportedly responding by buying CBA themselves to offset the positions taken by their external managers. In other words, being underweight CBA has hurt performance so badly that some funds are considering taking the decision away from their managers.
Fear of falling behind their peers or failing the prudential regulator’s performance test is proving more powerful than their conviction that CBA is overpriced.
If there’s a buying vortex it isn’t being created by index funds blindly pushing up prices. It’s being driven by active managers and super funds scrambling to reduce the career and regulatory risk of remaining underweight.
That doesn’t mean CBA’s critics are wrong; it is extraordinarily expensive. But expensive isn’t a catalyst. A high valuation may point to lower long-term returns but it doesn’t tell investors when the reversal will begin. That requires a change in earnings expectations, risk appetite, or the returns available elsewhere.
The results could provide that catalyst. An increase in bad debts, weaker margins, slower credit growth, or a cautious outlook could cause investors to question how much they’re prepared to pay for CBA’s future earnings. However, another steady result could do the opposite. CBA doesn’t need spectacular growth, it only needs to avoid disappointing investors.
Housing market impact
The longer term catalyst may eventually come from housing. The government’s changes to negative gearing and capital gains tax could reduce investor demand and put downward pressure on property prices. That could slow credit growth and eventually increase mortgage losses.
But correctly identifying the catalyst doesn’t solve the timing problem.
US housing had already turned down when Citigroup, then the largest bank in the US, reached its sharemarket peak in May 2007. Investors who correctly saw the housing downturn coming could still have lost money by betting against the bank too early.
CBA could also receive an unexpected boost from Australia’s new capital gains tax rules.
The changes could increase the relative appeal of reliable fully franked dividends. CBA won’t offer the highest yield, but investors may accept a lower yield in exchange for its balance sheet strength, earnings consistency and dividend reliability.
Next week’s results will provide a fresh test of CBA’s earnings and dividend outlook. It may also help determine whether the shares can continue towards $220 over the next year.
If CBA’s 2026-27 earnings per share increases to around $7.13 and it maintains a payout ratio near the top of its target range, its annual dividend could reach about $5.70. That’s an optimistic scenario and would require continued lending growth, resilient margins and low credit losses.
Including franking credits, the dividend would be worth around $8.14. At $220 a share, that would give investors a grossed-up yield of about 3.7 per cent and CBA would still trade at almost 31 times earnings.
That’s hardly cheap. But investors have already shown they’re willing to pay a huge premium for CBA’s balance sheet strength, earnings consistency and reliable income.
The less favourable tax treatment of future capital gains could make that income even more valuable.
While the CBA sceptics may eventually be proved right, right now – as underweight fund managers reverse their positions – the stock is likely to just keep pushing up and up. And that’s not the fault of any index fund.
Deciding whether a company like CBA is overvalued or still has further to run is difficult, even for professional fund managers. Stockspot builds and manages a diversified portfolio of low-cost ETFs, so your long-term investment strategy doesn’t depend on getting individual stock calls right.
This article was originally published as an opinion piece for The Australian – CBA’s share prize puzzle: the real force fuelling its high valuation (07 August 2026).
