Investors use various methods for valuing financial companies, such as discounted cash-flow valuation, residual income valuation, as well as price multiple and momentum valuation.
Dividend yield investing is another common approach. In its simplest form, dividend yield investing involves identifying among a group of comparable companies the firms offering the highest dividend yields and then investing in those companies.
Dividend yield investing is frequently justified on the grounds that: (1) dividends can represent a substantial portion of an investor’s return; and (2) dividends are a more stable and predictable source of return than price appreciation.
Arguments against dividend yield investing frequently center on the fact that: (1) dividends represent only a component of an investor’s total return and that the decision to buy or sell a security should not ignore possible price movements; and (2) higher dividend payout rates can displace future earnings and, as such, depress future stock prices and lower an investor’s total return.
That being said, in our experience, dividend yield investing is used most comfortably when valuing financial companies and, in particular, banks. This article will demonstrate the use of dividend yield investing and apply a ranking structure to five Canadian banks – Canadian Imperial Bank of Commerce (TSX:CM, Financial), Royal Bank of Canada (TSX:RY), Bank of Nova Scotia (TSX:BNS, Financial), Bank of Montreal (TSX:BMO, Financial) and the Toronto-Dominion Bank (TSX:TD, Financial).
Calculating dividend yields
A firm’s dividend yield is calculated by dividing its annual per share dividend by the price of the stock (D/P). In practice, analysts frequently use the trailing dividend yield for valuation purposes. This can be calculated as the sum of total dividends over the previous 12 months divided by the current stock price. Alternatively it can be calculated as 4x the most recent quarterly per share dividends divided by the current stock price. This is the method we will use here.
Dividend yield comparables
Below we consider the purchase of five Canadian bank stocks. Table 1 presents dividend yields on each position. To examine whether differences in yields can be explained by differences in risk and/or growth rates, we also present the companies' betas, earnings payout ratios and sustainable growth rates (calculated as three-year average ROEs times three-year average retention rates). We also provide each company’s rank position. That is, the values in the parentheses represent where each company ranks along each dimension – growth, beta, payout rates, yields – and their total rank scores represent the sum of their rank positions along each dimension.
Table 1: Using dividend yields to compare Canadian bank stocks
| Company | Sustainable Growth Forecast (%) | Beta | Dividend Yield (%) | Earnings Payout Ratio (%) | Rank Score |
| Canadian Imperial Bank of Commerce (CM) | 8.7 (1) | 0.48 (1) | 4.48 (1) | 49 (2) | 5 |
| Royal Bank of Canada (RY) | 8.0 (2) | 0.69 (4) | 4.15 (4) | 47 (1) | 10 |
| Bank of Nova Scotia (BNS) | 6.8 (3) | 0.57 (3) | 4.34 (2) | 49 (2) | 10 |
| Bank of Montreal (BMO) | 6.3 (4) | 0.52 (2) | 4.17 (3) | 49 (2) | 11 |
| Toronto Dominion Bank (TD) | 6.3 (4) | 0.48 (1) | 3.68 (5) | 47 (1) | 11 |
*Total rank score represents the sum of rank positions along each dimension; the lower the score the better.
Valuation
The Canadian Imperial Bank of Commerce and the Royal Bank of Canada exhibit the best sustainable growth rates. The Bank of Montreal exhibits the second-lowest market risk while it has the highest dividend payout ratio and third-highest dividend yield of 4.17%. This is slightly lower than the Bank of Nova Scotia — the company offering the second-highest dividend yield of 4.34%.
As for the company with the greatest combination of sustainable growth, low risk and dividend yield, Canadian Imperial Bank of Commerce is the clear winner, with a total rank score of 5. Toronto Dominion Bank provides the worst combination of growth, risk and yield, with a total rank score of 11. Bank of Montreal is also a poor performer with the lowest sustainable growth rate, the second-highest payout rate and the second-highest beta.
Now as a dividend yield investor, you must determine whether a dividend yield of 4.48% growing at a potential compound rate of 8.7% is sufficient enough to qualify for investment, given a payout ratio of 49% and a beta of 0.48. For gurus Leith Wheeler Canadian Equity (Trades, Portfolio) we know it is sufficient as, over the last two years, it has added over 555,000 shares to its position at an average price of $97.84. We value Canadian Imperial Bank of Commerce at about 2.2x book value per share, which is in line with its five-year average.
This implies a price target of about $115 and capital appreciation potential of 12.5% to 17.5%. Assuming a holding period of two years, and with a dividend yield of about 4.5%, a position in Canadian Imperial Bank of Commerce could earn investors a reasonable return.
