With Comprehensive Capital Analysis and Review (CCAR, or "stress test") results due out on Thursday, March 7th, money center bank investors are wondering what it means for the too-big-to-fail banks' capital return plans. RBC has provided some estimates of capital return levels it thinks are reasonable based on what it considers to be the best, average and least capitalized banks. Wells Fargo (WFC) is listed in the middle of the group in terms of capitalization and, thus, RBC thinks the Federal Reserve will allow the bank to return something like 50% to 75% of its earnings to shareholders when the capital return plans are released next week.
This is a significant development for shareholders as WFC has been somewhat restricted in recent years in returning capital to shareholders. The bank recently increased its quarterly payout to 25 cents per share, for an effective yield of about 2.8%. However, given what Wells has telegraphed regarding its capital return plans, we could see much, much higher yields in the near future.
Given that Wells has increased earnings per quarter sequentially for three years now and is a very well-capitalized bank, it is reasonable to assume the Fed will allow Wells to almost do whatever it wishes in terms of returning capital to shareholders. Indeed, the current 25 cent quarterly dividend represents a payout ratio of only 27% of 2013 estimated earnings. This is only half of what Wells has just said it will target as a payout ratio for the future.
Assuming Wells does indeed raise its payout ratio to, say, 55%, which is on the low end of the range it provided, shares would yield a whopping 5.6% at current prices. Of course, if Wells were to begin increasing its dividend towards a 50 cent quarterly distribution, which is what a payout ratio of 55% would represent for 2013, the stock would begin to move up in anticipation of such news. Just for kicks, the top end of the range Wells targeted (65%) for its payout ratio would represent a 6.5% yield at today's price and for 2014, a quarterly distribution of 63 cents would be possible.
Regardless of how quickly Wells begins to raise its dividend in the wake of the CCAR capital return plan results next week, a clear case can be made that Wells will be raising its payout soon and quite significantly over the next year or so. Wells has the earnings power and the balance sheet to continue to raise its dividend, effectively doubling today's yield. It is win-win for shareholders; either you get a doubled payout in a year's time or so with no capital appreciation or you get the same payout increase with commensurate capital appreciation.
The market will not allow Wells to have a dividend yield of 6.5% in today's ZIRP environment and, as such, when Wells' dividend increases do come to pass, price appreciation is a near certainty. Given how yield-starved investors are in the wake of QE Infinity, a stable grower like Wells Fargo increasing its yield will attract value and income investors for years to come. My best guess is that once the dividend is increased to a payout ratio of 50% to 60%, Wells will have appreciated enough to make a 50 cent quarterly distribution yield around 4%. If you are keeping score at home, that is $50 per share, or roughly 39% higher than where shares trade today.
Of course, this ignores the possibility of some of the capital returns to be in the form of buybacks, which will almost undoubtedly occur; however, I think this analysis shows that Wells is better off distributing that cash as dividends instead of buying back shares. Simply increasing the yield will increase the price of the shares because even if you don't believe in a growth story for WFC, a 5 or 6 percent yield would be too good to pass up. Wells will never see 40% share price appreciation by buying back stock.