Thesis article

Canadian banks have made significant investments in the past, due to above-average performance during recessions and because they tend to offer strong dividend payouts to their owners. The Toronto-Dominion Bank (NYSE: TD) and the Royal Bank of Canada (NYSE: RY) are two of Canada’s largest banks. In this article, we’ll pit them against each other to see which bank might be best suited for different types of investors.

Unless otherwise stated, all figures in this article are in US dollars.

Are TD Bank and Royal Bank of Canada worth investing in?

I believe the answer to this question is yes. Both banks have generated solid and reliable returns for their investors in the past:

The two banks have offered relatively comparable returns of around 180% to 190% over the past decade, including dividend payments. This corresponds to annual returns of around 11% for both companies, which is very solid. The broader market offered higher returns during this period, but was much more volatile. In fact, both TD and RY have a beta of just 0.5, which makes them quite attractive from a risk-reward perspective, I believe. Yields aren’t ultra-high but are still compelling and very reliable, which is, at least in part, down to their generous dividend policies.

How are TD Bank and Royal Bank of Canada different?

Both banks operate primarily in Canada, and the two companies have relatively comparable market capitalizations of around $130 billion to $140 billion. Both companies are also among the top 10 global banks by market capitalization, which is because equity investors reward them for their consistency and generous shareholder payout policy.

Nevertheless, there are some differences between these two Canadian banks. Royal Bank of Canada operates in Canada, the United States and what it calls international markets:

Its activities abroad generate more than 40% of the bank’s income. Canada remains by far the most important market, but the bank nevertheless has considerable exposure to the United States and other international markets, including countries in the Caribbean, Europe, the Middle East, etc.

Toronto-Dominion, on the other hand, places greater emphasis on its domestic markets. It only operates in Canada and the United States. The retail business in the United States is responsible for just under 30% of its profits, with the rest generated by the retail and wholesale business in Canada, as well as a stake in the publicly traded company Charles Schwab (SCHW).

Toronto-Dominion is larger in terms of total assets and deposits, but trails slightly behind Royal Bank of Canada in earnings and market capitalization.

TD and RY Stock Key Indicators

During the last quarter, Royal Bank of Canada managed to generate net profits of C$4.1 billion, which equates to approximately $3.2 billion, or nearly $13 billion annualized. The company’s strong profitability in the last and previous quarters, combined with management’s conservative approach, has resulted in a very strong capital position. The bank’s common equity tier 1 (CET1) ratio stands at 13.5%, which is well above the average for large banks. If the bank wanted to, it could reduce this ratio over the next few years in order to increase shareholder returns.

But even without using available balance sheet flexibility, the bank offers its owners strong shareholder returns. Between 2011 and 2021, the Royal Bank of Canada has increased its dividend by 110%, or about 8% per year. In 2022, the bank will likely pay CA$4.80, or $3.72. This translates to a dividend yield of 3.7% at current prices, which is quite high compared to the dividend yields offered by most major US-based banks. At the same time, the combination of a yield close to 4% and a (historic) dividend growth rate of 8% looks attractive to investors focused on dividend growth. There’s no guarantee that dividends will grow at the same rate in the future, but thanks to RY’s strong track record and the fact that its payout ratio is quite low, just above 40%, I think there is a high probability that investors will also obtain significant and reliable dividend increases in the future.

Toronto-Dominion generated a net profit of 14.6 billion Canadian dollars in 2021, which amounts to 11.3 billion dollars. This was significantly more than in the previous year, which can be explained by the lower provisioning of credit losses that the bank undertook in 2021, compared to the previous year where the impact of the pandemic was more important. That being said, its fourth quarter earnings were below the level of the prior year quarter, which was due to a drop in revenue generation which could not be offset by lower expenses. Yet even in this quarter, TD remained very profitable, generating C$3.8 billion in net profit, which equates to C$2.9 billion. Toronto-Dominion’s Tier 1 common equity ratio was 15.2% at the end of the most recent quarter, which is even higher than that of Royal Bank of Canada.

Toronto-Dominion’s dividend history is excellent:

Toronto-Dominion has paid dividends for a very impressive 164 years, and the company has increased its dividend very consistently over the past few years. Between 1995 and 2021, the dividend has increased by 1,300%, or 11% at an annualized rate. This growth has slowed to some extent in recent years, but even the 5-year dividend growth rate is at a fairly attractive 8.2%. At current prices, Toronto-Dominion offers a dividend yield of 3.8%.

It can therefore be said that Toronto-Dominion offers a slightly higher dividend yield and has a better history of dividend growth, while operating with a higher CET1 ratio compared to the Royal Bank of Canada. That being said, RY also looks pretty good on those metrics, and it has a slightly lower dividend payout ratio (42% vs. TD’s 44%).

What is the outlook for TD and RY stocks?

Both companies are good investments from a fundamental perspective, but of course valuations should also be considered when making investment decisions.

Both banks are currently trading at roughly the same valuation, as TD is valued at 11.4 times this year’s earnings per share estimate, while the multiple is 11.5 for RY. Both companies are trading at a slight discount to how they were valued, on average, in the past. A return to the historical valuation norm would allow upside potential of around 7%-8% for both companies.

When we add the fact that both companies are expected to increase their earnings per share over time, thanks to business growth and buyouts, and when we take into account the attractive dividend yields of both banks, it can be said that both companies today look like attractive investments.

Analysts currently expect Toronto-Dominion to grow earnings per share by nearly 8% per year going forward, while Royal Bank of Canada is expected to generate earnings per share growth of 4% per year. Personally, I think the gap probably won’t be as big in future years, mainly due to the fact that both companies have grown their earnings per share almost perfectly in the past. A sudden big divergence of this magnitude therefore doesn’t seem very likely to me, although TD still gets the point for the somewhat better growth prospects going forward. That being said, even a 4% earnings per share growth rate is far from bad when combined with a near 4% return and a discount to historical valuation norm.

Are TD Bank or Royal Bank of Canada stocks the best buy?

Both companies are fundamentally sound, have performed well during the pandemic and past recessions compared to many other financial institutions, and both offer a strong dividend yield while trading at an inexpensive valuation.

However, Toronto-Dominion still wins this one, I believe. Its dividend yield is a little higher, its dividend growth a little faster, its expected growth in earnings per share is better than that of the Royal Bank of Canada. In addition to this, Toronto-Dominion also has the higher CET1 ratio which makes it even more stable and reliable compared to Royal Bank of Canada.

Royal Bank of Canada doesn’t do badly at all on these metrics, but Toronto-Dominion looks a bit better, which is why I consider it the more favorable choice. That being said, one can of course hold both, as both banks seem like suitable choices for a reliable, low-risk dividend growth portfolio.