Why do Canadian banks pay such a high dividend yield? What does this mean for investors?
All major Canadian banks offer their shareholders relatively high dividends. On average they pay 4.01%, which largely exceeds the 2.9% yield offered by the S&P/TSX Composite Index.
The earnings cycle
In general, companies have three options on how to utilize their earnings:
- Retain and reinvest them in the company or make acquisitions, which will arguably fuel earnings per share (EPS) growth over time.
- Buy back shares. By doing so, the company divides its earnings base across fewer shares, thereby boosting the EPS.
- Pay out dividends.
As we can see, the three above options boil down to a choice between a higher payout to shareholders now and higher EPS growth in the future. In general, stock prices tend to follow EPS growth. As a result, higher dividend payouts translate into lower future capital appreciation, as less money gets reinvested in the company.
What’s noteworthy about banks?
Canadian banks have the luxury of stable earnings. Furthermore, their business is fairly mature, so they have limited reinvestment opportunities for retained earnings. As a result, banks tend to pay out a larger percentage of their earnings per share than most public companies.
At the other end of the spectrum, a lot of information technology and biotech companies benefit from greater growth opportunities and, as a result, they tend to reinvest more of their earnings and pay out less.
The bottom line
High dividend stocks do not necessarily provide higher expected returns. They just tend to deliver more of their returns in the form of dividends and less in the form of capital appreciation.