Why it’s Not the Best Time to Buy the Big Banks

The big banks in Canada, with Royal Bank of Canada (TSX:RY)(NYSE:RY) as the leader, were the most profitable Canadian companies in 2015. Why should you wait before buying these great companies?

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There’s no question that the big banks in Canada are quality companies. In fact, the Big Five banks were the most profitable Canadian companies in 2015.

To keep this article brief and to the point, the focus will be on the most profitable banks: Royal Bank of Canada (TSX:RY)(NYSE:RY) and Toronto-Dominion Bank (TSX:TD)(NYSE:TD).

Long-term earnings growth

Looking back in history, Royal Bank of Canada and Toronto-Dominion Bank have had long-term trends of growing their earnings in the last two decades. In fact, they were profitable every year–they didn’t have negative earnings in a single year.

Since right before the financial crisis (i.e., the fiscal year 2007) to 2015, Royal Bank of Canada and Toronto-Dominion Bank compounded their earnings per share (EPS) by 5.9% and 6.1% per year, respectively.

These were higher growth rates compared to the remaining Big Five banks, which compounded their EPS by 1.3-4.5% per year during that period.

Stable, growing dividends

The big Canadian banks are known for their quality, financial strength, and stability. And their steady earnings growth has led to safer dividends.

From the fiscal years 2007 to 2015, Royal Bank of Canada and Toronto-Dominion Bank compounded their dividends per share (DPS) by 6.8% and 8.4%, respectively.

Both leading banks expanded their payout ratios, but the latter had a lower payout ratio in 2007 and higher subsequent earnings growth that led to faster-growing dividends.

These were higher growth rates compared to the remaining Big Five banks, which compounded their DPS by 2.3-5.7% per year during that period.

The banks’ dividends remain safe with payout ratios of less than 50%. Specifically, in the fiscal year 2016, Royal Bank of Canada’s and Toronto-Dominion Bank’s payout ratios are expected to be about 48% and 45%, respectively. And the remaining Big Five banks’ payout ratios are expected to be 46-49%.

So what?

If Royal Bank of Canada, Toronto-Dominion Bank, and the other big Canadian banks are growing their earnings and dividends, why is it not the best time to buy their shares?

The answer is simple. There’s no margin of safety for an investment today. The banks are trading near their 52-week highs. Based on their normal trading multiples, the banks are at best trading at fair valuations.

As the stock market is near its high, interested investors can be a little more cautious by preserving their capital. Instead of buying the banks at fair valuations, they can wait for pullbacks to buy at discounted valuations to get higher starting yields and likely higher long-term returns.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng owns shares of  Toronto-Dominion Bank.

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