A Look at the Canadian Banking Industry

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Today, I’ll be reviewing The Bank of Nova Scotia (NYSE: BNS) as part of my Great Canadian Banking Series. In this 10-part series, I will examine the Canadian Banking Sector to identify good dividend growth candidates.

Side Note: Since the article is focusing on a Canadian sector, I chose to show stock information from the Toronto Stock Exchange instead of the NYSE. Dollar amounts and stock information are in Canadian dollars.

Dividends

The Bank of Nova Scotia has increased its dividend for two consecutive years in a row, which doesn’t sound very impressive, but a look at its website informed me that it had dividend increases in 42 of the last 45 years. This is very impressive.

The most recent dividend increase happened with the dividend recorded in April 2013 when it increased the quarterly dividend 5.3% from $0.57 to $0.60. Recently, it has been increasing its dividend twice a year, so the most recent annual dividend increase would be from $0.55 to $0.60, which is a 9.1% increase.

In the chart, you can see where dividend growth slowed around 2008-2010. The overall trend is good, but dividend growth has been slow since 2008.

Dividend growth

As you can see from the table below, Bank of Nova Scotia shows a good 10-year average annual dividend growth rate, but leaves me wanting more with the other rates.

Only the 10-year average rate is above the 8% I like to see, but it looks like dividend growth might be improving with the more recent dividend increases showing improved growth.

Estimated future dividend growth

In the past few years, the payout ratio has been around 40%-50% and other banks like Canadian Imperial Bank of Commerce (NYSE: CM) and Bank of Montreal (NYSE: BMO) have stated that they are targeting a payout ratio of 40%-50%. Based on this, it looks like Bank of Nova Scotia is targeting 40%-50% too.

Analysts expect annual EPS growth to be 8.74% for the next five years. Accepting this EPS growth rate and using a payout ratio of 40%-50% would result in annual dividend growth ranging from 7.7%-12.6%.

The company’s most recent annual dividend increase of 9.1% leads me to think that future annual dividend growth will be around 8%-10%.

Competitive advantage

The Canadian banking industry is dominated by six highly competitive banks. Bank of Nova Scotia is known as a more international bank compared to the other Canadian banks, so it is also competing with international banks. Overall, I would say that Bank of Nova Scotia has a narrow economic moat.

Valuation

Morningstar currently rates Bank of Nova Scotia a three-star stock as it is currently priced around its estimated fair value of $62. The five-star stock price is $37.20. I calculated my own target price and came up with $51. To see the details of this calculation read the full analysis of Bank of Nova Scotia.

My target price of $51 is 37% higher than Morningstar’s five-star target. This is quite a difference, so I was worried that my target price wasn’t conservative enough. Whenever I need a tie breaker for valuation, I like to use dividend yield. The five-star price would result in a dividend yield of 6.5%, and my target price gives a yield of 4.7%. When I look at the past 10 fiscal years, it looks like a yield of 4.7% is still conservative compared to past dividend yields.

Morningstar’s five-star price is very conservative, and it looks like the only opportunity to buy at a 6.5% yield would’ve been in 2009 at the height of the global financial crisis. Having looked at historic high dividend yields, I’m content to keep my target price at $51. You can see all of my target prices here.

Other investment options in the same industry

Bank of Nova Scotia is one of six banks that make up the majority of the Canadian market. They share the industry with: Toronto-Dominion Bank, Royal Bank of Canada, CIBC, Bank of Montreal, and National Bank.

All the banks offer a good entry dividend yield with rates ranging between Toronto-Dominion Bank’s 3.84% to CIBC’s 5.14%. With the exception of CIBC and Bank of Montreal, the banks show a similar trend in their dividend growth rates. The 10 year rates are good, but due to the global financial crisis, the three and five year rates are low, and the one year rate shows an improvement.

CIBC and Bank of Montreal haven’t shown the recent improvement in dividend growth rates that the others have. The dividend growth rates shown in the table are based on the dividends recorded in each calendar year from 2003 to 2012.

They all offer reasonable payout ratios with rates ranging from National Bank’s 40.00% to Bank of Montreal’s 49.50%. Looking at the various payout ratio histories of all the banks and reading their annual reports, it looks like the standard payout ratio target for the big six banks is 40%-50% with the exception being National Bank.

Based on past payout ratios, National Bank looks like it is targeting a payout ratio of 30%-40%. Using these payout ratio targets, the current EPS and the analyst’s five year annual EPS growth estimates, I calculated an annual dividend growth estimate for each of the banks.

Bank of Montreal’s target payout ratio of 40%-50% is shown on its website, so I feel fairly confident in my dividend growth estimate of 4.9%-9.7%. In the past year, Bank of Montreal increased its quarterly dividend from $0.70 to $0.72 and then again to $0.74. This is an annual increase of 5.7%. Prior to these two increases, the dividend was held steady for a number of years with the previous increase recorded with the November 2007 dividend when it was increased from $0.68 to $0.70.

Bank of Montreal was the slowest of the big six banks to recover from the financial crisis and begin dividend increases again. While the dividend increases appear to have started again, it is not at the 8% or above rate I like to see. With its most recent increase, it looks like the dividend increases will be at the lower to middle range of my dividend growth estimates.

CIBC recently increased its quarterly dividend from $0.90 to $0.94 with the dividend recorded in September 2012, and then again from $0.94 to $0.96 with the dividend recorded in June 2013. The annual increase from $0.90 to $0.96 is 6.7%. This would suggest that dividend growth will be at the higher end of my estimate of 3.0%-7.7%, but still below the 8% I typically like to see. CIBC has stated that their target payout ratio is 40%-50% so I feel like my estimate should be fairly close.

From a dividend growth perspective, National Bank, Bank of Nova Scotia, and TD Bank show the most promise. I think Royal Bank of Canada offers appealing fundamentals too, but prefer the previous three banks just mentioned. I think CIBC and Bank of Montreal will offer lower annual dividend growth below my target of 8%, which is why I don’t plan on investing in them.

Conclusion

Like all banks, Bank of Nova Scotia was hit hard by the global financial crisis, but it looks to be getting back to its old self. This is good news for dividend growth investors. Right now, Bank of Nova Scotia is a little above my target price, but should it come down to $51, I’d consider investing more into Bank of Nova Scotia. I expect future dividend growth of 8% to 10%.

This, coupled with a good entry yield above 4%, makes it an enticing investment option. There are other banks that offer similarly enticing dividend fundamentals, so it might just be a matter of waiting for the first one to fall below my target price. Should this happen, I’d consider investing in National Bank, Bank of Nova Scotia, Toronto-Dominion Bank, or Royal Bank of Canada.

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Michael Weber owns shares of Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and The Bank of Nova Scotia. The Motley Fool recommends The Bank of Nova Scotia (USA). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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