The banking sector is quite cyclical. It means companies part of this sector are positioned to generate higher earnings during periods of economic expansion. Typically, demand for loans gains pace during bull markets, resulting in higher earnings for banks.
Alternatively, during economic downturns, slower consumer spending and higher delinquencies result in a tepid lending environment, dragging profit margins lower.
In the last two years, rising interest rates have acted as headwinds for global banks, due to which stocks operating in the financial lending space have trailed the broader markets. For instance, shares of Royal Bank of Canada (TSX:RY) are down 10% from all-time highs, valuing the TSX giant at $190 billion by market cap. The drawdown has meant it offers shareholders a dividend yield of 4.1%, given its annual payout of $5.52 per share.
Let’s see if you should buy Royal Bank of Canada stock at the current valuation.
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The bull case for RBC stock
Royal Bank of Canada is one of the largest banks in Canada. Armed with a diversified business model with scale, it offers a full suite of products and services for clients. It enjoys a market-leading presence in Canada and an established multi-platform strategy south of the border with a long runway for premium growth.
Its industry-leading ROE (return on equity), strong balance sheet, and prudent risk management have allowed RBC to deliver market-beating returns to long-term shareholders.
In the last 20 years, RBC stock has returned roughly 840% to investors after adjusting for dividends, much higher than the TSX index, which has surged “just” 360%.
How did RBC perform in fiscal 2023?
In fiscal 2023, RBC generated earnings of $15 billion with an ROE of 14.2%. It ended the year with a strong CET1 (common equity tier-one) ratio of 14.5%, the highest in its history. The CET1 ratio is used to measure a bank’s ability to withstand economic shocks, and a higher ratio is preferable.
RBC enjoys a top-two market share across product categories in Canada. It is the largest investment bank in the country and ranks ninth globally. In terms of assets under management, it is the largest retail mutual fund company in the country and the sixth-largest full-service wealth advisory firm in the U.S.
RBC aims to increase earnings by 7% annually in the next three years while maintaining an ROE of 16%. A widening earnings base should support consistent dividend growth for the RBC. In the last 24 years, it has paid shareholders a dividend each year while navigating downturns such as the dot-com bubble, the financial crisis, the COVID-19 pandemic, and recent interest rate hikes, as well as inflation.
Moreover, these payouts have increased by more than 10% annually in the last 25 years, which is exceptional for a bank stock.
The Foolish takeaway
RBC is a blue-chip stock which should be part of your equity portfolio. It enjoys an entrenched position in Canada, making it too big to fail. Moreover, RBC stock trades at 11.8 times forward earnings, which is reasonable given its earnings forecast and tasty dividend yield.
