Dividend Yield Investing in Canadian Financials

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 6 Canadian chartered banks – Royal Bank of Canada (RY, Financial), Toronto Dominion Bank (TD, Financial), the Bank of Montreal (BMO, Financial), Canadian Imperial Bank of Commerce (CM, Financial), the Bank of Nova Scotia (BNS, Financial), and the National Bank of Canada (NA, Financial).

Calculating dividend yield

A firm’s dividend yield is calculated by dividing its annual per share dividend by the price of the stock (D/P). In practice, analyst frequently use the trailing dividend yield for valuation purposes. This can be calculated as sum of total dividends over the previous 12 months dividend by the current stock price. Alternatively it can be calculated as 4 times the most recent quarterly per share dividend divided by the current stock price. This is the method we will use here.

Dividend yield comparables

Below we consider the purchase of six 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 and Sustainable Growth Rates (calculated as 3-year average ROEs times 3-year average retention rates). We also provide each company’s rank position. That is, the values in the parenthesis represent where each company ranks along each dimension – growth, Beta, yield – 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

Valuation

The National Bank of Canada and the Canadian Imperial Bank of Commerce exhibit the best sustainable growth rates. The Toronto Dominion Bank exhibits the lowest market risk while it also has the lowest dividend yield and the second-lowest sustainable growth rate.

As for the company with the greatest combination of sustainable growth, low risk and dividend yield, the Canadian Imperial Bank of Commerce is the clear winner, with a total rank score of 4. The Royal Bank of Canada provides the worst combination of growth, risk and yield, with a total rank score of 15.

Now as a dividend yield investor, you must determine whether a dividend yield of 3.9% is interesting enough to hold your interest. For Canadian Guru firm Leith Wheeler Canadian Equity (Trades, Portfolio) we know it is interesting enough to recently add over 600,000 shares valued at over $50M to the company portfolio.