Bank of Nova Scotia has a highly profitable business model, and reported solid growth across its most important financial measures in 2018. The company has multiple catalysts for continued growth in the years ahead, which should fuel cash returns to shareholders.
While stock valuations of U.S. banks have risen significantly over the past five years, Bank of Nova Scotia appears undervalued. This is a strong Canadian dividend stock and a worthwhile holding for income investors interested in diversifying their portfolios.
Industry Position Leads to High-Quality Earnings
The Bank of Nova Scotia (often called Scotiabank) is the third-largest financial institution in Canada behind only the Royal Bank of Canada (RY) and the Toronto-Dominion Bank (TD) . Scotiabank has nearly $1 trillion of assets and operates in three segments: Canadian Banking, International Banking, and Global Banking & Markets. Canadian Banking represents half of earnings, while International Banking and Global Banking & Markets represent 32% and 18% of earnings, respectively.
Shares of the company are cross-listed on the Toronto Stock Exchange as well as the New York Stock Exchange. Bank of Nova Scotia has a market capitalization of around $70 billion.
Bank of Nova Scotia performed well in 2018, even though the year was marked by growing fears of a global economic slowdown. The company's earnings per share rose 8% for the 2018 fourth quarter and 5% for the year. Net interest income advanced 10% as all of its segments reported growth. International Banking saw earnings rise 18% and Canadian Banking earnings were up 7%. Asset growth and net interest margin expanded in the quarter.
Bank of Nova Scotia had a strong efficiency ratio of 52.3% in 2018, an improvement from 53.9% in the previous year. Additionally, it reported satisfactory return on equity and common equity tier 1 ratios of 14.5% and 11.1%, respectively.
Bank of Nova Scotia has also employed a strategic acquisition policy to boost its growth. Last year, it acquired Jarislowsky Fraser and MD Financial Management to bolster its wealth management business. It has also turned to acquisitions to expand its international banking business. In 2018, the company acquired the retail and credit card business and the small and medium enterprise operations of Citibank in Colombia.
Aided by a favorable macroeconomic backdrop, Bank of Nova Scotia has enjoyed strong and consistent growth over the past several years. From 2008 to 2018, the company grew its adjusted EPS by 9% per year. With steady EPS growth, it has rewarded shareholders with dividend growth as well. In the past 10 years, Bank of Nova Scotia grew its per-share dividend by 6% per year, on average.
Bank on a High Dividend Yield
In U.S. dollars, Bank of Nova Scotia pays an annual dividend of $2.56 per share. This equates to a hefty dividend yield of 4.5%. It is worth noting that Canada imposes a 15% dividend withholding tax. However, the withholding tax is waived for U.S. investors who hold the stock in a qualified retirement account, such as a 401(k) or IRA.
Bank of Nova Scotia's 4.5% dividend yield compares very favorably to many of its U.S.- based peers. For example, U.S. banks such as Bank of America (BAC) and JPMorgan Chase (JPM) yield 2.1% and 3.1%, respectively. This makes Bank of Nova Scotia particularly appealing for investors looking for a higher level of dividend income, such as retirees.
Scotiabank has a secure dividend payout. It had a dividend payout ratio of 46% in 2018, meaning the company distributed less than half of its EPS in the form of a dividend to shareholders. This was a fairly modest payout ratio, which allows for continued dividend increases in the years ahead, particularly if EPS continues to rise. Another factor helping to secure the dividend is the company's financial strength. Bank of Nova Scotia has a credit rating of A+ from Standard & Poor's and Aa2 from Moody's.
Attractive Valuation and Expected Returns
In addition to a high dividend yield, Bank of Nova Scotia is an attractive stock on the basis of valuation. The company is expected to generate EPS of $5.62 (in U.S. dollars) in 2019. Based on this, shares currently trade for a price-to-earnings ratio of 10, a fairly low valuation for such a high-quality company. It is also trading slightly below its long-term average P/E ratio. The stock held an average P/E ratio of about 12 over the last decade. If the stock returns to its historical average valuation, the increasing P/E multiple would boost annual returns by approximately 4% per year over the next five years.
Plus, shareholder returns will be increased by EPS growth and dividends. Bank of Nova Scotia is expected to grow EPS by 8% annually through 2024. The stock also offers a 4.5% dividend yield, leading to total expected returns of 16.5% annually over the next five years. This is a very attractive rate of return and makes Bank of Nova Scotia a buy for value and income investors.
Nick McCullum is a regular contributor to Real Money. Click here to get columns like this each day from Jim Cramer, Stephen "Sarge" Guilfoyle, Helene Meisler and Jim "Rev Shark" DePorre.
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