Scotiabank has the Cheques and Balances to Justify its Valuation

Yes, Canadian banks are trading at valuation multiples unseen in years.

However, comparing these multiples to their historical valuations may not make all that much sense. The banking industry has changed drastically over the years. 

Decades ago, banks were mostly just mortgage lenders. They would take in deposits from savers, keep a very small fraction of it in the vault, and lend out all the rest. Previous borrowers that Canadian banks would lend to weren’t always the most creditworthy. While conservative compared to our American neighbours, the credit standards back then would never pass muster today against modern regulations.

In addition to requiring the borrower to have stronger credit and solvency, the regulator (called the Office of the Superintendent of Financial Institutions, or OSFI) now disallows banks from lending out as much money from its deposits as it did 15 years ago.

Banking has also become a lot more diversified. In addition to mortgage lending, banks now rely on wealth management and capital markets to contribute a large portion of their earnings. These two areas benefit from lower interest rates, which counter the squeeze on margins that banks can expect on their mortgage portfolio whenever the cost of borrowing falls.

All this is to say that because banks are more prudent (albeit because of regulations) and more diversified than previously, the risk-reward isn’t nearly the same as it was before. However, safer, less volatile companies deserve to trade at a higher valuation multiple than firms that take on greater risk and uncertainty.

Our choice for our client portfolios the last few years has been the Bank of Nova Scotia (“BNS”). (Disclosure: Clients, Jeff Pollock, and Sunni Schneider have a financial interest in BNS. No compensation was received to publish this content.)

After years of staring at a flatlining stock chart, BNS shareholders have enjoyed almost a 60% return the last two years. Add in the $8.62 in dividends per share earned along the way, and that return jumps closer to 70%.

In its most recent quarter, there was impressive growth posted across the board. Adjusted earnings per share grew 33% compared to the same period the year before (excluding the release of “provisions”, which is rainy day money that management no longer felt was necessary to hold onto for an emergency, the “pre-tax pre-provisions” earnings grew 16%), surpassing analyst expectations. 

Results were strong enough that the board of directors hiked its dividend by four percent, the biggest jump since 2022. While we’re not getting the 5% dividend yield we were when we first started buying this for clients because of the stock price appreciation, today’s near-4% current yield is still better than all its Canadian peers, whose yields are all in the 2.5 to 2.9% range.

This brings me to the reason we wanted to write about this topic. Many are saying that because the Canadian banks are trading at such lofty valuations, it’s time to take profits.

Selling stock depends on which bank you’re referring to.

Because BNS is increasing its return on equity, meaning they are generating a higher profit for every dollar investors have put into the business, the earnings per share is set to grow in the teens for four consecutive years, something unseen since before the 2008 financial crisis.

BNS remains the cheapest of the five big banks, though it has for many years. Its price-to-earnings ratio for next fiscal year is almost 15% cheaper than the median peer valuation. While it looks expensive at 14x this year’s earnings, because of the earnings growth we expect to take place over the next few years, the valuation multiple falls to 13x next year and 11x the year after that, which is much more in line with its ~11x historical valuation multiple.

Unlike its peers, BNS also has a large international banking segment in Latin America, which mostly targets Mexico, Chile, and Peru. BNS used to trade at a premium because Latin America was a growth driver, but its volatility and unpredictability has weighed on the valuation in recent years. Today, Latin America is benefitting from a commodity price boom. Further political disruption in the region that attracts business-friendly governments will undoubtedly help BNS grow if Latin America begins to attract corporate investment.

Because BNS is cheaper than its peers; has double-digit earnings growth on the horizon; and would benefit from future Latin America investment as commodity prices soar, we will continue to hold this stock in client portfolios.

-written by Jeff Pollock