A Quest For Dividend Growth in 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 Royal Bank of Canada (NYSE: RY) as part of my Great Canadian Banking Series. In this 10-part series, I 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.

10-year stock chart

The 10-year annual average return is 8.2%. If we include the dividend payments over the past ten fiscal years (total dividends paid of $20.73) then the total average annual return would be 10.7% with the average return from dividends representing 2.5%.

<img alt="" src="http://g.fool.com/editorial/images/61198/royal-bank-10-year-stock-chart-july-26-2013_large.JPG" />

Revenue & earnings per share

Revenue per share for Royal Bank of Canada has been declining since 2007, but we see a growing EPS from 2009 on. This would suggest that the company is getting more efficient. I like that EPS is growing, but I’d like to see revenue per share grow as well.

<img alt="" src="http://g.fool.com/editorial/images/61198/rbc-revenue-per-share-eps_large.JPG" />

Dividends

Royal Bank of Canada has increased its dividend for 2 consecutive years. Prior to this, the annual dividend was held at $2.00 for the three fiscal years from 2008 to 2010. The dividend streak leading up to the stalled dividend in 2008 was 14 years.

The quarterly dividend recorded in April of $0.63 (up from $0.60) was its most recent increase, but it's been increasing the dividend twice a year for the past few years. The quarterly dividend recorded in October 2012 was increased from $0.57 to $0.60. The most recent annual dividend increase would be from $0.57 to $0.63 which is an increase of 10.5%.

<img alt="" src="http://g.fool.com/editorial/images/61198/rbc-dividends_large.JPG" />

In the chart you can see where dividend growth stalled from 2008-2010. The overall trend is good, and it looks like dividend growth has started to improve since the global financial crisis.

Dividend growth

As you can see from the table below Royal Bank of Canada shows good 1 and 10-year average annual dividend growth rates, but leaves me wanting more with the other rates.

<img alt="" src="http://g.fool.com/editorial/images/61198/rbc-dgrs_large.JPG" />

Estimated future dividend growth

Royal Bank of Canada stated in its 2012 annual report that it is targeting a payout ratio of 40-50%. This is consistent with other banks like CIBC and Bank of Montreal, which have stated the same targets.

Analysts expect annual EPS growth to be 8.0% for the next five years. Accepting this EPS growth rate and using a payout ratio of 40-50% would result in dividend growth of 4.9% to 9.7%. The company’s most recent annual dividend increase of 10.5% leads me to think that future dividend growth will be at the higher end of this range, likely around 8%.

Competitive advantage & return on equity

Looking at the table below, it looks like Royal Bank’s ROE has been in-line with the industry average.

<img alt="" src="http://g.fool.com/editorial/images/61198/rbc-roe-competitors_large.JPG" />

The Canadian banking industry is dominated by the big six banks. The big six are all very competitive, so while there are not a lot of big players in the Canadian market, it is still very competitive. Overall I would say that Royal Bank of Canada has a narrow economic moat.

Valuation

Morningstar currently rates Royal Bank of Canada as a 3 star stock as it is currently priced close to its estimated fair value of $57. For Morningstar to rate Royal Bank of Canada as a 5 star undervalued stock the price would have to fall below $34.20. I calculated my own target price and came up with $50. To see the details of this calculation read the full analysis of Royal Bank of Canada.

My target price of $50 is 46% higher than Morningstar’s 5 star target. This is quite a difference, so I was worried that my target price wasn’t conservative enough. Looking at the past ten fiscal years worth of the highest dividend yield’s I think my target price is still conservative. The 5 star price would result in a dividend yield of 7.4%, and my target price a yield of 5.0%. A yield of 5.0% is still conservative compared to past dividend yields.

<img alt="" src="http://g.fool.com/editorial/images/61198/rbc-low-dividend-yields_large.JPG" />

Morningstar’s 5 star price is very conservative, and it looks like the only opportunity to buy at a 7.37% yield would’ve been in 2009 in the height of the global financial crisis. Having looked at historic high dividend yields, I’m content to keep my target price at $50. You can see all of my target prices here.

Other investment options in the same industry

Royal Bank of Canada is one of six banks that make up the majority of the Canadian market. It shares the industry with Bank of Nova Scotia (NYSE: BNS), Toronto-Dominion Bank (NYSE: TD), CIBC, Bank of Montreal, and National Bank (TSX: NA).

<img alt="" src="http://g.fool.com/editorial/images/61198/rbc-competitors-table-1_large.JPG" />

All of the banks offer a dividend yield of around 4% or higher, which is enticing. They range between Toronto-Dominion Bank’s 3.67% to CIBC’s 4.91%. Their payout ratios are all reasonable with them ranging from National Bank’s 40.00% to Bank of Montreal’s 49.50%.

When it comes to dividend growth and estimated 5-year annual EPS growth CIBC and Bank of Montreal look a little lackluster compared to the other banks. I think National Bank, Bank of Nova Scotia and Toronto-Dominion Bank show the most promise. Royal Bank offers appealing fundamentals, but I prefer the other three banks just mentioned.

Bank of Nova Scotia has increased its dividend for 2 consecutive years, which doesn’t sound very impressive until you look at the bigger picture. It has increased its dividend in 42 of the last 45 years. This is very impressive. The most recent dividend increase happened with the dividend recorded in April, when management increased the quarterly dividend by 5.3% from $0.57 to $0.60.

Recently, management has been increasing the 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. The company’s most recent annual dividend increase of 9.1% leads me to think that future dividend growth will be around 8-10%.

Like most of the big six banks Toronto-Dominion Bank has increased its dividend twice in the past year. This led to an annual dividend increase of 12.5%. My guess is that future dividend growth will be at the higher end of my estimated range of 6.4-11.2%.

In the past year National Bank increased its quarterly dividend from $0.79 to $0.83 and then again to $0.87. This is a 10.1% annual increase. I expect annual dividend growth at the higher end of my estimated range of 5.6-11.9%. National Bank has the lowest payout ratio of all the banks, which also suggests that it has the best ability to grow its dividend. That said, National Bank typically likes to keep its payout ratio lower than the other five banks.

There are a number of good dividend growth candidates among the Canadian banks, but overall I like National Bank’s dividend growth prospects the best.

Conclusion

Right now Royal Bank of Canada is above my target price, but should it come down to $50 I’d consider adding to my current position. At $50 the dividend yield would be an enticing 5.0%, and I expect future annual dividend growth around 8%. 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 Royal Bank of Canada, Bank of Montreal, Canadian Imperial 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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