What’s the best investment for your Tax-Free Savings Account (TFSA)? Ones that can surely make you money! Right now, the odds are with buyers of Bank of Nova Scotia (TSX:BNS) who have a long-term investment horizon.
Durable earnings
Big Canadian banks like Bank of Nova Scotia are in a desirable position. In a well-regulated operating environment that is dominated by a few large players (the Big Six Canadian banks, including Scotiabank), they are able to make solid returns through economic cycles.
For example, even during the hard-hit pandemic year of 2020, Bank of Nova Scotia still achieved a return on equity of about 10.4% and reported net income of just under $6.8 billion. For reference, its five-year return on equity is roughly 13.5%. In the trailing 12 months (TTM), the bank reported net income of almost $9 billion. Close to $8.7 billion were net income available to common shareholders. This results in a TTM payout ratio of just under 60%.
Payout ratio is relatively high today
This payout ratio is at the high end of BNS stock’s historical range. In fact, this is the second highest since (as far as I can see) fiscal 2003. The highest payout ratio of 67% was — not surprisingly — recorded in the 2020 pandemic year. Even then the bank did not cut its dividend. And it’s likely to maintain its dividend this time around.
During recessions, the regulator Office of the Superintendent of Financial Institutions (OSFI) would restrict the federally regulated banks like Scotiabank from buying back shares and raising dividends to help maintain the stability of our financial system.
As economists expect a mild recession to occur later this year in Canada and the United States, it’s likely that Scotiabank could freeze its dividend for some time. Other than anticipating a recession, the bank stock’s payout ratio is high, and its earnings growth has staggered in recent years. These are all reasons that the bank stock has underperformed and, therefore, offers the highest dividend yield in the sector.
ZEB and BNS data by YCharts
As shown above, Scotiabank recently underperformed, even after accounting for its relatively high yield.
Valuation and dividend yield
No matter from the perspective of price to book or price to earnings, Bank of Nova Scotia appears to be cheap. The graph below shows the 10-year history of its price to book.
BNS Price to Book Value YCharts
Bank of Nova Scotia stock’s long-term normal price-to-earnings ratio is about 11.4. A reversion to the mean can drive upside of approximately 38%. Currently, investors are probably waiting for Scotiabank’s new chief executive officer (CEO) Scott Thomson to prove himself. It could take him a few years to start turning the bank’s performance around. In the meantime, investors can lock in a juicy dividend yield of 6.2% in the undervalued stock.
Investor takeaway
Bank of Nova Scotia stock’s 10-year dividend-growth rate is 6.4%. The new CEO potential to reignite growth for the bank could lead to outsized total returns over the next five years as well as long-term dividend growth. It is not a dream anymore to accumulate the blue-chip shares in the TFSA to lock in a high passive income that has a good chance of extraordinary returns for the long haul.
