The One Number That Could Spoil This Canadian Dividend Stock’s Rally

A tiny move in RBC’s credit-loss provision could matter a lot because bank valuations are already stretched.

Amy Legate-Wolfe

Author Bio Amy became interested in investing in 2018 after having her first daughter. After receiving a masters degree in journalism from Western University, she became frustrated that the finance industry remained a confusing place for Canadians like her: new parents, millennials, and other young people who needed to understand their finances. Now, Amy focuses on tech companies and renewable energy for growth opportunities, coupling that with long-term investing strategies and equities. She also provides investors with a daily newsletter, Canada Stock Digest, for daily market updates. Her work can also be found at Canada's National Observer, where she writes on the business side of climate action. Before joining Motley Fool Canada, Amy wrote for major news organizations including HuffPost, CTVNews.ca, and CBC. When she’s not researching investing strategies, Amy’s time is pretty much monopolized by her two wild daughters, but in what little spare time she has she loves to do yoga, go on walks with her dog, and travel with her husband. Social Media Follow Amy on LinkedIn and Canada Stock Digest. Favorite Investment Quote “October: This is one of the particularly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” – Mark Twain

Published August 11, 11:45 am EDT

| More on: RY

Key Points

Banks’ provision for credit losses ratio is a key early warning, and small increases can crush profits.
RBC’s earnings and dividend growth look strong, but the stock price leaves little room for disappointment.
Watch RBC’s PCL ratio near 35 basis points at the next report, and add only on weakness.

A number smaller than one half of one percentage point could spoil a 63% rally. That sounds absurd until the number represents nearly $1 billion of profit slipping through a bank’s fingers. With Canadian financial stocks trading near their richest valuations in years, even a small disappointment can suddenly look enormous.

customer uses bank ATM — Source: Getty Images

PCL

That number is the provision for credit losses (PCL) ratio. Banks set aside money when they expect some borrowers won’t repay their loans. Dividing those provisions by average loans produces the PCL ratio, usually measured in basis points. One basis point equals 0.01 percentage points.

Lower provisions leave more revenue available for profit and dividends. Higher provisions do the opposite, even before a loan is actually written off. That makes PCL a useful early warning for Canadian bank stocks, particularly when unemployment, consumer delinquencies, commercial real estate, or business failures begin moving the wrong way.

The timing raises the stakes. Financials climbed 22% since February and now represent 37% of the TSX, their largest weighting in eight years. Canada’s five biggest banks traded at an average of 15 times forward earnings, compared with 12 times for their largest U.S. peers. Expectations are doing plenty of heavy lifting before the banks report again in late August.

RBC earned its rally

Royal Bank of Canada (TSX:RY) is Canada’s largest bank by market capitalization. It earns money through personal and commercial banking, wealth management, insurance, and capital markets. That mix provides several engines, so one sleepy mortgage market doesn’t have to leave the entire company napping.

The latest results justified plenty of optimism. Second-quarter net income increased 25% year over year to $5.5 billion, while adjusted earnings per share (EPS) rose 25% to $3.90. Profit improved across every business segment, and lower provisions on performing loans helped. RBC stock then raised its quarterly dividend 7% to $1.76 per share.

RBC stock recently traded near $294.50, roughly 62% above its $181.60 52-week low and just 4% below the high. The new $7.04 annualized dividend produces a modest 2.4% yield. RBC stock’s trailing price-to-earnings ratio of approximately 19 also leaves less room for an ordinary quarter to wear a superhero cape.

Watch 35 basis points

Now to the PCL. RBC’s total PCL ratio fell to 35 basis points in the second quarter from 41 one quarter earlier. Total provisions declined 16% sequentially to $912 million, providing an important tailwind for earnings. The impaired-loan portion was 34 basis points, or $899 million, and management maintained its full-year guidance.

That’s the number to check when RBC reports on August 27. Another stable or lower reading would suggest borrowers remain resilient and allow more of RBC’s revenue growth to reach the bottom line. A sharp increase could signal that the credit cycle is worsening, forcing analysts to reduce earnings estimates while the stock’s valuation already assumes continued strength.

The warning lights haven’t disappeared, however. Gross impaired loans rose by $623 million during the quarter to $9.8 billion. RBC identified pressure in U.S. commercial real estate, forest products, consumer discretionary companies, and credit cards, particularly in Ontario. Softer employment, tariffs, or stubbornly high borrowing costs could push more loans from merely uncomfortable to impaired.

Foolish takeaway

So should investors get in before earnings? RBC stock remains one of the strongest Canadian dividend stocks. Its 13.5% common equity tier-one ratio provides a healthy capital cushion, its 42% second-quarter payout ratio left the dividend well covered, and its scale supports long-term earnings growth. None of that makes the current price cheap.

I’d hold existing shares and add gradually rather than chase the rally days before earnings. Long-term investors don’t need to flee because one credit metric might wobble, although they shouldn’t pay any price for quality either. If the PCL ratio rises and the market overreacts, patience may turn August’s most dangerous number into a much better entry price.