Last year, amidst the volatility in the equity markets, the price war on oil, and the economic contraction from the COVID-19 pandemic, many questioned the sustainability of Canadian bank dividends. However, a year later, the situation has transformed and our team is less concerned. To gain a better outlook on dividends, we review the current and expected payout ratios, earnings expectations, capital levels, and changes to the regulatory environment.
The Big Six Canadian banks have historically held target payout ratios of 40-50% of earnings. This range has allowed banks to maintain steady dividends even when facing volatile earnings in the short term. However, in May 2020, bank earnings estimates took a severe hit. As a result, banks carried payout ratios of 60-70% and uneasiness grew. Still, this was not yet considered to be an alarming range. Earnings estimates would have had to drop an additional 30 to 40% before payouts would begin exceeding 100%. At the time, this event was considered unlikely however, it was not completely inconceivable given the considerable uncertainty in the economy.
The table below shows the FY2021 and FY2022 consensus earnings estimates and considers the situation where dividends remain constant from their current levels. Despite FY 2021 payout ratios at the upper end of the 40-50% range described earlier, they show significant improvement from their 2019 counterparts. FY2022 shows even greater improvement, where bank payout ratios are situated in the upper-middle range.
Although consensus estimates are not yet fully available nor will they be very precise for FY 2023, assuming an 8% EPS growth target, the ratios show that they will be in a comfortable target payout range. Overall, this implies that banks may not need to adjust their dividends to keep within their targeted payout rates.
Bank earnings are expected to rebound and show significant growth in FY 2021 and FY 2022. It can be argued that such growth should mean that dividends should be increased once permitted by regulators. However, the last column in the table shows that on average, these estimates are still below past 2019 earnings. Therefore, it is hard to entertain the idea of large dividend increases when earnings are flat and even possibly negative relative to the prior three years.
Capital and the Regulator
Last year, it was argued that banks should be able to hold a steady dividend stream due to their strong capital levels. Banks were better capitalized and in a stronger position to withstand the 2020 economic shock compared to the 2008 financial crisis. This level of capitalization can be demonstrated by the increase of the banks’ Common Equity Tier 1 (CET1) ratio from sub-8% in 2008 to 11.5% in 2019. RBCCM expects that CET1 ratio for the banks will reach 12.8% by the end of FY 2021. The continual increase in capital can be attributed to the Office of the Superintendent of Financial Institutions (OFSI) who prescribed in March 2020 that all federally regulated financial institutions were to suspend dividend increases and share buybacks indefinitely. These restrictions remained as of this January and maybe repealed depending on the state of the economic recovery. It is possible that the capital restrictions are lifted later this year, however, there may be alternative options for bank capital that dictate that slow dividend growth is more advantageous. These options include repurchasing their own shares and engaging in M&A activities, which require large amounts of capital.
As earnings will not immediately return to pre-pandemic levels, we believe that dividend increases may not be the priority of Canadian bank CEOs. However, we cannot ignore the robust capital levels of our Canadian banks which permit such increases. The big 6 banks have displayed a resilient 20-year track record of growing their dividends at a 9% annual growth rate and the option is still there to continue to return capital to shareholders. Ultimately, with valuations below historical averages and under the context of an improving global economy in the later part of 2021, we believe a market weight for banks in portfolios is warranted. An earlier than expected dividend increase may be a bonus for investors.