Published September 7th, 2016 by Ben Reynolds
Toronto-Dominion Bank (TD) [hereafter referred to as TD] is one of the oldest and largest banks in Canada.
TD was created in 1955 through the merger of the Bank of Toronto and the Dominion Bank. Both banks had a long corporate history:
- Bank of Toronto was founded in 1855
- Dominion Bank was founded in 1869
TD is one of the largest banks in North America. The company currently has a market cap of over $83 billion.
Source: TD 3rd Quarter Investor Presentation, slide 6
What immediately stands out about TD stock is its favorable metrics.
- 10 Year compound earnings-per-share growth rate of 10.1%
- Price-to-earnings ratio of 13.5
- Dividend yield of 3.7%
- Payout ratio of 48%
The company’s reasonable payout ratio, high yield, solid growth, and low price-to-earnings ratio help it rank as a buy using The 8 Rules of Dividend Investing.
TD breaks its operations down into 3 primary sectors: Canadian Retail, US Retail, and Wholesale. TD also owns 42% of TD Ameritrade. The image below gives a breakdown of the relative size of each segment (and the TD Ameritrade investment).
Source: TD 3rd Quarter Investor Presentation, slide 7
This article analyzes the compelling investment prospects of TD in detail. Keep reading to learn more about the potential risks and returns of investing in TD.
TD recently (8/24/16) reported 3rd quarter 2016 results. Adjusted earnings-per-share grew 5.8% versus the same quarter a year ago.
The company’s Canadian Retail segment saw revenue grow 3%. Income fell to $1.5 billion from $1.6 billion. The decline was due to higher insurance claims from the Fort McMurray wildfires.
The United States retail segment experienced significant growth. Net income grew 19% to $663 million in the United States retail banking segment. The increase was due to cost cutting and strong revenue growth. TD Ameritrade contributed another $125 million to the United States retail segment – up 31% from the same quarter a year ago. Higher trading volumes drove the excellent growth.
The Wholesale Banking segment also produced excellent results, growing income 26% versus the same quarter a year ago. Growth came from higher activity across the wholesale banking segment’s various offerings.
Overall, TD had a reasonably good quarter. The company’s rapid growth in its smaller segments more than made up for weakness in the company’s largest segment, Canadian Retail.
TD has similar risk factors to large Canadian Bank (and competitor) Royal Bank of Canada (RY). These risk factors are exposure to oil and gas companies and exposure to the overpriced Canadian real estate market.
Fear over TD’s oil and gas loan exposure is largely misplaced. The company does not have significant exposure to the oil and gas industry. Earnings-per-share have continued to grow for the company while oil prices have plunged. The image below sheds further light on the size of TD’s oil and gas loan portfolio.
Source: TD 3rd Quarter Investor Presentation, slide 17
The company’s exposure to the Canadian mortgages is more troubling. The company has $252 billion in loans for Canadian real estate. 58% of this mortgage portfolio is uninsured. If housing prices collapse in a similar fashion to how they did in the United States, the company would experience losses.
This is a worst case scenario. Canadians typically have more equity in their homes and have historically had lower default rates. If default rates approached 5% annually like they did during the height of the housing crisis, TD would see losses of around $12 billion. Again, this is an absolute worst case scenario, and is unlikely. To put this loss into perspective, the company has net profit of around $6 billion a year. The company would not see its cash flow go down by $12 billion, but would rather take a 1 time hit on the value of its loan portfolio. The company’s dividend and future growth prospects would be safe regardless.
Even the worst case scenario does not pose a serious long-term threat to TD. The company is a high quality bank that is relatively conservatively managed.
Competitive Advantage & Recession Performance
TD has a strong competitive advantage in the financial industry due to its size and reputation. The larger a bank gets, the more locations it has, making it more convenient for customers. While online banking has made banking more convenient, physical locations still matter.
TD’s size and stability give it an advantage in the retail banking industry in Canada and on the East coast of the United States. The company’s locations are shown in the image below.
Source: TD 3rd Quarter Investor Presentation, slide 3
The company’s management has shown skill at allocating capital effectively. This is reflected in the company’s 10.1% earnings-per-share growth rate over the last decade. Dividends have grown quickly as well; at a 12% pace since 1995.
TD has proven to be fairly recession resistant as well (for a bank). This speaks to the conservative nature of the company. Not all banks performed well during the Great Recession. The company’s earnings-per-share through the recession and subsequent recovery are shown below.
- 2007 earnings-per-share of $2.74 (all time high at the time)
- 2008 earnings-per-share of $2.44
- 2009 earnings-per-share of $1.74 (recession low)
- 2010 earnings-per share of $2.55
- 2011 earnings-per-share of $3.21 (all time high at the time)
Even during the worst of the great recession, TD’s earnings covered its dividend. The company’s payout ratio was 70% in 2009.
Growth Prospects & Total Return
TD is experiencing strong growth in its United States and TD Ameritrade businesses. The company has a long growth runway ahead in the United States. TD currently only has significant geographic exposure on the east coast of the United States. Continued geographic expansion will result in more growth for TD.
The company has compounded earnings-per-share at 10.1% a year over the last decade. TD’s management is targeting adjusted earnings-per-share growth of 7% to 10% a year over the next several years. I believe the company will be able to grow near the high end of expectations over the next several years through a mix of organic growth, and possible net interest margin improvements.
With a 3.7% dividend yield and expected earnings-per-share growth of 7% to 10% a year, shareholders can expect total returns of 10.7% to 13.7% a year going forward from TD.
Valuation & 8 Rules Rank
TD is currently trading for a price-to-earnings ratio of 13.5. The company has historically traded for a price-to-earnings ratio multiple of 0.75x that of the S&P 500 over the last decade.
The S&P 500 is currently trading for a price-to-earnings ratio of around 25. This implies a fair price-to-earnings ratio of between 18 and 19 for TD. The company appears undervalued relative to the market at current prices.
Banks have historically traded for lower valuation multiples as compared to the S&P 500. This is reflected in the company’s 0.75x price-to-earnings ratio multiplier relative to the S&P 500. The banking sector has in large part not benefited from expanding price-to-earnings ratios in other sectors. As a result, high quality banking stocks like TD currently look undervalued relative to the S&P 500.
As mentioned at the beginning of this article, TD currently ranks very well using The 8 Rules of Dividend Investing. The company’s rank over each metric is shown below, along with a brief ‘why it matters’ section.
Consecutive Years of Dividend Increases: TD has never cut its dividend in its 150+ year history (using Canadian dollars). The company’s historical dividends back to 1969 can be found here.
Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 3.2 percentage points per year.
Source: S&P Factsheet
Dividend Yield: TD’s high 3.7% dividend yield is the 27th highest out of the 186 dividend stocks in the Sure Dividend database (all of which have 25+ years of dividend payments without a reduction).
Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 2.2 percentage points per year from 1928 to 2013.
Source: Dividends: A Review of Historical Returns
Payout Ratio: TD’s current payout ratio of 48% is the 70th lowest out of 186. Lower payout ratios are preferred (all other things being equal) because they provide more safety for the dividend, and the potential for dividends to grow faster than earnings in the future.
Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3
Long-Term Growth Rate: I expect TD to grow its earnings-per-share at around 9.6% a year going forward, in line with historical growth. The company has the 43rd highest growth rate out of the 186 stocks in the Sure Dividend database.
Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends from 1972 through 2015.
Source: An Economic Perspective on Dividends
Long-Term Volatility: TD has a 10 year annualized stock price standard deviation of 27.3%. This ranks it 80th out of 186 for low volatility in the Sure Dividend database.
Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
Source: Low & Slow Could Win the Race
United States investors should be aware of possible 15% dividend tax withholding from Canada. Due to a tax treaty between the United States and Canada, this withholding can be waived for qualified retirement accounts like 401Ks and IRAs.
TD is a high quality banking stocks with a low price-to-earnings ratio. The company makes a compelling buy based on its high yield and high expected growth rate (which give it high expected total returns). TD is an example of a high quality business trading below fair value.