Double Your Wells Fargo Dividend

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

Wells Fargo (NYSE: WFC) is Warren Buffett's favorite bank. Berkshire Hathaway (NYSE: BRK-A) owns 422.5 million shares of the bank, almost 8% of the total outstanding shares. This holding currently makes up 19.4% of Berkshire's portfolio, and Buffett has been actively buying more shares. These facts lead me to believe that Buffett maintains unwavering confidence in the future of Wells Fargo.

Wells Fargo pays a modest dividend with a yield of 2.66% based on the current market price of $33.01 per share. Of the four major US banks, only JP Morgan Chase (NYSE: JPM) pays a higher dividend (2.92%). Both Bank of America (NYSE: BAC) and Citigroup (NYSE: C) pay a token penny/share/quarter dividend, yielding a fraction of 1% in both cases.

After a steep drop in the dividend during the financial crisis, the dividend has grown from $0.05 quarterly in April 2009 to $0.22 quarterly most recently. That's a factor of 4.4 in just three-and-a-half years, or 52% annualized. Because the dividend has grown from such a suppressed level due to the financial crisis, the growth rate will probably decrease in the coming years, but Wells Fargo may be on its way to becoming a solid dividend growth stock.

Is Wells Fargo cheap?

Valuing a financial company can be a bit tricky. A traditional free cash flow analysis works poorly with this type of company. So first, let's take a look at earnings per share.

Wells Fargo has seen EPS increase from $1.75 in 2009 to $2.82 in 2011, well above pre-financial crisis levels. In the third quarter of this year EPS came in at $0.88, 22% greater than the same quarter last year. The current consensus analyst estimate for 2012 is $3.35 per share. With a current share price of $33.14, this puts the P/E ratio at a humble 9.89.

Book value is a much more relevant measure for banks than for normal companies. On the balance sheet, shareholders' equity is defined as total assets minus total liabilities, which is exactly what book value is. Wells Fargo had a book value of $154 billion as of the end of the third quarter, or $28.88 per share. This puts the P/B ratio at a modest 1.15.

I would consider a P/E of 9.89 and a P/B of 1.15 fairly inexpensive. Wells Fargo is a much more conservative bank than its peers, which is one reason why Buffett likes the company so much. Although other banks sport lower P/B ratios, some of the assets on their balance sheets have questionable value. Bank of America has a P/B of just 0.5, while Citigroup has a P/B of 0.6 and JP Morgan has a P/B of 0.8. However, due to the "toxic" nature of some of their assets (relics from the financial crisis), these low P/B values don't mean much. Wells Fargo, having managed the financial crisis in a more conservative fashion, should be in better shape than its competitors. I surmise this is the main reason for Buffett's preference.        

Increase your income

Although a 2.66% dividend yield is higher than the S&P 500 average, there are plenty of companies which pay a richer dividend. However, there is a way to increase the effective dividend yield on shares of Wells Fargo you currently own.

Selling covered call options is one of the most conservative, and popular, option strategies. The buyer of a call option buys the right, but not obligation, to purchase shares of the underlying stock at the strike price on or before the expiration date from the seller of the call option. The buyer pays the seller a premium for this right. There are two possible outcomes with this strategy:

  1. The underlying stock price stays below the strike price and the option expires worthless. The seller of the call option is not forced to sell any shares, and new call options can now be written on the position.
  2. The underlying stock price rises above the strike price and the option is exercised, either on expiration or before. The seller of the call option is obligated to sell shares of the underlying stock to the buyer of the call option at the strike price, which will be below the current market price.

This strategy is ideal for someone who owns at least 100 shares of the underlying stock and wants to generate additional income from their position. The risk, as outlined in scenario two above, is having your shares called away if the stock price rises. This can be at least partially mitigated by choosing a strike price well above the current market price and an expiration date no more than 1-2 months away.

Which option to sell?

Before choosing which option to sell we need to set a goal. First, I want to minimize the chance of having my shares called away. Second, I want the combined annual yield from the dividend and the call option to be roughly twice that of the dividend alone. This means that the call option must produce an annualized yield of around 2.66%.

A good choice using these parameters is the Jan 13 $36 call option. The strike price is 9% above the current stock price (and only 1.6% below the 52-week high), while the expiration date is only 43 days away. The stock would have to rise 9% in the next 43 days for the option to be at risk of being exercised. The bid price for this option is $0.11, which means that each option contract sold would generate $11 in income (since option contracts are in blocks of 100 shares). Given the current share price of $33.14, the premium represents an annualized yield of 2.82% (0.333% in 43 days), just above our 2.66% goal. The total annual yield from both the dividend and this call option would then be 5.48%, a substantial improvement.

If you're willing to take on more risk of having your shares called away then you can improve your effective yield even more. The Jan 13 $35 call option has a strike price that is 6% above the current market price but offers a premium of $0.27. The annualized return of this option is 6.9%, creating an effective total yield of 9.56%.

The bottom line

Selling covered call options allow you to increase the effective yield of your holdings in exchange for taking on the risk of being forced to sell those holdings. By choosing a strike price 9% above the current market price and an expiration date less than two months away this risk is greatly reduced. This strategy allows you to nearly double the effective yield on your Wells Fargo holdings, from 2.66% to 5.48%. Obviously, this strategy is not for everyone, especially if you are reluctant to risk having your shares called away. But for some, this offers an attractive way to generate additional income.

TheBargainBin has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. 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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