Getting paid to wait sounds like a pretty much perfect arrangement. That said, it loses some of its charm when you’ve already paid full price for the thing you’re waiting on. A bank stock can send you a dividend every quarter and still disappoint if you buy after everyone else has spotted the comeback.
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Follow the money beyond the dividend
A bank dividend comes from the earnings left after paying staff, funding loans and setting aside money for borrowers who might fall behind. The amount distributed tells me what I could collect today. The profits that stay inside the bank help determine how much it can pay a few years from now.
For Canadian dividend stocks, I like to compare the cheque with the price I’d pay for each dollar of earnings. If profits rise while investors pay the same multiple, the share price can rise along with them. If the multiple shrinks, better earnings can still leave the shares treading water. I’d also compare the size of the dividend with the amount I could lose if the market marks down bank valuations. A couple of quarterly payments can soften the blow, but it takes years of them to make up for buying at a price that assumed too much.
That’s a real possibility after a bank’s recovery becomes popular. I’d separate earnings the bank has already delivered from the improvement I’m being asked to pay for. So let’s dig into this top banking stock.
What’s actually improving at TD
Toronto-Dominion Bank (TSX: TD) collects deposits, makes loans and sells financial services on both sides of the border. Its U.S. business gives it more room to grow over time, though restrictions tied to its anti-money-laundering failures limit how much certain U.S. bank subsidiaries can expand.
TD reported third-quarter adjusted earnings of $2.77 per share, up from $2.20 a year earlier. Nine-month adjusted earnings reached $7.59 per share versus $6.19. I like seeing the improvement across more than one quarter. It gives me something to work with without pencilling in an end date for the U.S. restrictions.
The quarterly dividend of $1.12 is about 40% of that quarter’s adjusted earnings. At the recent close of $172.92, the annualized yield was about 2.6%. The cheque is part of the case, though it’s too small to rescue a purchase made at an overly generous price.
Considerations
Here’s the test I’d run. Assume the market pays 16 times annual earnings in each scenario. The figures are examples of what the price would be at that multiple, before dividends. To be clear, they’re not earnings forecasts.
| ANNUAL EARNINGS PER SHARE | EXAMPLE PRICE AT 16 TIMES | CHANGE FROM $172.92 |
|---|---|---|
| $10.00 | $160.00 | −7.5% |
| $11.00 | $176.00 | +1.8% |
| $12.00 | $192.00 | +11% |
That table tells me more than a big percentage increase in one quarter. At that multiple, TD would need nearly $10.81 in annual earnings per share just to support the starting price. An existing shareholder collecting the dividend has a different decision from someone choosing where to put fresh money.
That works in the other direction too. If the U.S. operation eventually has more freedom to expand and can use it profitably, I’ll want to see the improvement in the earnings per share. I wouldn’t assign the bank extra value just for being allowed to grow again.
I’d watch for earnings growth that holds up when loan losses rise or the Canadian economy slows. If I’m adding the stock inside a Tax-Free Savings Account (TFSA), I’d also check how much bank exposure I already have through funds. TD’s a large business, and my portfolio doesn’t need to be its unofficial branch office.
Bottom line
I’d hold a position I’m comfortable with and give TD time to build on those results. For new money, I’d be more interested at a price that gives me room for a slower recovery and leaves the next earnings surprise working in my favour.
