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Daniel Seens
Daniel Seens
Articles (82)  | Author's Website |

Which Canadian Bank Would Make the Best Investment?

A dividend yield framework for ranking Canada's 5 big banks

May 12, 2017 | About:

Every quarter we like to reflect on which trades have performed well and which trades have performed poorly. In the last quarter some of our best-performing trades were in the Canadian financial sector. What we want to know is if we should consider further increasing our positions in Canadian bank stocks for long-term investments and, if so, which banks we should be considering.

Which method should we consider if we are looking at the big Canadian banks for long-term investments? Investors use various methods for valuing financial companies, such as discounted cash-flow valuation and 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 from among a group of comparable companies the ones 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 facts that: (1) dividends represent only a component of an investor’s total return and 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 (NYSE:CM), Royal Bank of Canada (NYSE:RY), Bank of Nova Scotia (NYSE:BNS), Bank of Montreal (NYSE:BMO) and the Toronto-Dominion Bank (NYSE:TD).

Calculating dividend yields

A firm’s dividend yield is calculated by dividing its annual per share dividend by the price of the stock. 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 Rate

Rank Score

Canadian Imperial Bank of Commerce

9.3% (1)

0.99 (3)

4.5% (1)

44% (1)

6

Royal Bank of Canada

8.7% (2)

1.02 (4)

3.6% (3)

48% (3)

12

Bank of Nova Scotia

7.3% (3)

1.43 (5)

3.9% (2)

50% (5)

15

Bank of Montreal

5.7% (5)

0.82 (2)

3.6% (3)

49% (4)

14

Toronto Dominion Bank

7.2% (4)

0.80 (1)

3.5% (4)

46% (2)

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 also having the second highest dividend payout ratio and third-highest dividend yield of 3.6%. This is slightly worse than the Bank of Nova Scotia  the company offering the second-highest dividend yield of 3.9%.

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 6. The Bank of Nova Scotia provides the worst combination of growth, risk and yield with a total rank score of 15. Bank of Montreal is also a poor performer with the lowest sustainable growth rate and the second-highest payout rate.

Now as a dividend yield investor, you must determine whether a dividend yield of 4.5% growing at a potential compound rate of 9.3% is sufficient enough to qualify for investment, given a payout ratio of 44% and a beta of 0.99. For gurus Leith Wheeler Canadian Equity (Trades, Portfolio) and Signature Select Canadian Fund (Trades, Portfolio) we know it is not sufficient as, over the last year, they have closed or reduced their positions selling over 1.8 million shares at an average price of $88.25 per share. We value Canadian Imperial Bank of Commerce at about 2.1x book value per share, which is in line with its five-year average.

Figure 1: CIBC Price Line and Target Price Line at Equilibrium P/B Multiple, 1997-2016

Assuming CIBC can continue to grow the value of its book by about 2.8% per year (which is significantly lower than its five-year and 10-year average growth rates of 9.6% and 6.6%) this would imply a price target of about $130 and capital appreciation potential of about 19%. Assuming a holding period of three years with a dividend yield of about 4.5%, a position in Canadian Imperial Bank of Commerce could earn investors a sizable return, provided our estimates prove accurate.

Disclosure: We currently hold long positions in Canadian Imperial Bank of Commerce and Bank of Nova Scotia.

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About the author:

Daniel Seens
SEENSCO, a Canadian Corporation founded by Daniel Seens, CFA, is an investment research firm located in Ottawa, Ontario. Our Safety-First approach to identifying and evaluating companies helps investors to protect their principal and generate exceptional rates of return. For a 7-day free trial please visit our website at www.seensco.com.

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