This is the first of six dividend stock analyses I am conducting for Canadian bank stocks I already own or am considering for future investments. Several of the Canadian banks, including Bank of Nova Scotia (NYSE:BNS), are classic dividend growth stocks with a long history of stable and predictable earnings and dividend increases. Although all of the Canadian banks fall within a fairly narrow range of dividend yields, payout ratios and PE multiples, subtle differences in these factors, and more significant differences in earnings and dividend growth rates, can translate into significant differences in total returns for long-term investors.
The Bank of Nova Scotia (also known as Scotiabank) was founded in 1832 and has paid uninterrupted dividends since 1833. It is the third largest bank in Canada by market capitalization. The Bank provides various personal, commercial, corporate, and investment banking services in Canada and internationally. It operates in four segments: Canadian Banking, International Banking, Global Wealth & Insurance, and Global Banking & Markets. BNS has the highest percentage of foreign operations of the Canadian banks and offers services in the Caribbean, Latin America, Central America, and Asia. This foreign development strategy has fueled much of the Bank's growth over the past decade, and is forecast to provide continued growth for at least another decade, but comes with higher risk and volatility associated with these emerging markets. The Bank is interlisted on the TSX and NYSE under the symbol BNS.
Revenue, Earnings and Dividend History
When evaluating dividend growth stocks I subscribe to the principle that dividend growth is a function of earnings growth and that earnings growth is a function of revenue growth. I like to see a long history of increases in these each of values over time. I also like to see how the company performs through at least one business cycle or sector downturn. I am not particularly concerned about declines in revenues and earnings for 1-2 year periods, so long as the trend is clearing rising over time and can recover its trajectory after a downturn. Likewise, I am not too concerned about a company missing the odd annual dividend increase when times are tough. However, a dividend cut is a big red flag. Good dividend growth companies should be able to maintain their dividend through business downturns.
BNS has paid dividends continuously since 1833 and increased its dividend in 42 of the last 45 years. Over the last decade revenues, earnings and dividends have increased all increased between 6.1%-7.5% (Compound Annual Growth Rate (CAGR)). All figures and calculations are in CAD unless otherwise stated.
The higher growth of dividends over earnings is reflected in the expansion of the payout ratio from 37% to 45%.
BNS, and other Canadian banks, came through the financial crisis of 2008-09 relatively well compared to many American and foreign institutions. This was largely due to Canadian government regulations that limited the banks' exposure to sub-prime mortgage backed securities, collateralized debt obligations, and associated derivatives. Although earnings for BNS were reduced during the financial crisis, they had recovered to the pre-crisis trajectory by 2011. The dividend rate was maintained during the crisis but the streak of annual increases was interrupted between 2009 and 2011.
I estimated total returns for BNS over the last 10 years using year-end data and reinvesting dividends once per year at the end of each year. Using this approach a $10,000 investment at the beginning of 2005 would now be worth $24,467 (CAGR = 9.4%) and have a yield-on-cost of 8.5%.
Source: Created by author
Using USD prices with dividends re-invested quarterly, a chart from buyupside.com indicates the yield-on-cost for an investment in 2005 would be just over 10%:
Earnings and Dividend Forecasts
The current dividend payout ratio is 45%, which is at the high end of the Bank's stated target of 40-45%. Therefore, expansion of the payout ratio is unlikely and future dividend increases are likely to be in line or slightly below future earnings growth.
Analysts estimate the future 5 year earnings growth for BNS will be 10.1%, which is 1% lower than the previous 5 years.
To forecast the potential return of BNS over the next 10 years I used an earnings growth rate of 8%, which is the average of the 6% historic rate and 10% 5-year estimate. For the dividend growth rate I used 7%, which is slightly less than earning growth to account for the current payout ratio being at the high end of target. Using these assumptions, an investment of $10,000 would grow to $29,638 (CAGR = 11.5%) and generate a yield on cost of 8.9% after 10 years.
Source: Created by author
Obviously, historic performance and future estimates are no guarantee of actual returns. However, I believe forecasting exercises are useful because 1) they focus me to critically assess growth predictions/assumptions and 2) I find potential returns to be one useful factor to compare stocks with different dividend and growth profiles. Total return estimates can be especially useful for dividend growth stocks, where the returns are a combination of dividends and capital appreciation, and the total returns are less transparent than the returns from growth stocks or fixed income investments.
Timing and Valuation
BNS is currently 6% off its recent all-time high of $74.35 on July 31. On November 4th the Bank released information that it expects to record certain charges in its fiscal 2014 fourth quarter earnings, aggregating to a total of approximately $451 million pre-tax, or $341 million after tax, which translates to $0.28 per share. It appears the Bank is using this situation to clean house by combining several charges, write-downs, restructuring expenses, and layoffs into one bad news event and aggregating earnings impacts into this next quarter. Although this will have a modest negative impact to Q4-2014 earnings, this should be a one-time event and, in the long run, contribute to future profitability and earnings growth.
I typically do not use absolute valuation targets (e.g. a PE ratio<20) to assess stocks because the appropriate benchmark to use varies across sectors, stocks within sectors, and relative to current broad market valuations. Instead, I focus on comparing the current price of a stock relative to historic valuation metrics and invest at or below average valuations.
The following table shows the historic price valuation for BNS relative to past earnings and dividend multiples, and provides an estimated current share value based on the historic multiples. BNS has maintained a PE ratio in the range of 10-14 over the last 10 years, except during the financial crisis when the PE dropped as low as 7. The price:dividend ratio has ranged between 23-34, except for a low of 13 during the financial crisis. BNS's recent price of $70 is within 5% of historic earnings and dividend multiples, indicating an average valuation.
BNS is a classic dividend growth stock with a long history of stable and predictable earnings and dividend increases. As a diversified bank, BNS should continue to benefit from economic expansion in Canada and the global markets it operates in. BNS has good valuation metrics with a low PE of 11.7, a relatively high dividend yield of 3.8%, and moderate payout ratio of 0.45. Based on historic performance and analyst estimates, earnings and dividends are forecast to grow 6-10% annually in the future. Given these factors I believe BNS is an attractive stock to hold in a diversified dividend growth portfolio. The recent pullback in share price has brought the stock price down from a record high in July to average historic valuations.
Disclosure: The author is long BNS.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.