The Most Promising Dividends in Big Banks

Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the banking industry offer the most promising dividends.

Yields and growth rates and payout ratios, oh my!
Before we get to those companies, though, you should understand just why you'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

• The current yield
• The dividend growth
• The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering into banking
Below, I've compiled some of the major dividend-paying players among big banks (and a few smaller outfits), ranked according to their dividend yields:

Source: Motley Fool CAPS.  

Dividend investors typically focus first on yield. M&T Bank (MTB 0.20%) is among the highest yielders, recently offering 2.9%. But it's not necessarily your best bet. M&T's payout ratio, while well within a healthy range, is far higher than many other banks' ratios, meaning it has less room to grow its payout. That's not a disqualification, though. M&T Bank is buying the well-regarded Hudson City Bancorp (NASDAQ: HCBK), which itself has been a solid dividend payer, recently yielding 4%. The deal will expand M&T's network, adding 135 Hudson City branches, but also brings with it a lot of Hudson City debt.

Instead, it can be smart to focus on the dividend growth rate first, but -- whoops -- the banking sector got whacked in the massive credit crisis of a few years ago, with most of them slashing dividends. Many have since been raising them again, but five-year average growth rates for most banks are ugly right now, and present an extra challenge. What the table does reveal, though, is that M&T Bank and BB&T (TFC -0.19%) are the only ones with positive growth rates over the period. BB&T has been bypassing many riskier investments while boosting its commercial loan portfolio and posting strong performance figures.

It's smart in this case to dig deeper and look more closely at some of these companies' dividend payouts. US Bancorp (USB 0.89%), for example, might have an ugly looking five-year average, but over the past two years, it has nearly quadrupled its dividend, while Wells Fargo (NYSE: WFC) has more than quadrupled its dividend. My colleague Sean Williams has praised US Bancorp's CEO for an impressive performance, with the bank outperforming most of its peers handily while focusing on boring, traditional banking activities over higher-risk alternatives such as derivatives.

Keep in mind, too, that some of these banks currently sport such low dividends that even steep growth rates may not bring them to attractive levels for a while. Bank of America (NYSE: BAC), for example, cut its $0.64 quarterly dividend in half in 2008, and then whacked it all the way down to $0.01 in 2009, leaving it with a yield of less than half a percent. Meaningful increases can happen in short order, though. State Street (STT -0.47%) took its own dividend from $0.24 per quarter to just $0.01 between 2008 and 2009, but it jumped to $0.18 in 2011 and $0.24 in 2012, recently yielding a solid 2.3%. The bank is viewed as a relatively solid and conservatively run one, and it's planning on buying back up to $1.8 billion worth of its shares.

Just right
As I see it, US Bancorp and Wells Fargo offer the best combination of dividend traits, sporting some solid income now and a good chance of strong dividend growth in the future. They're also well regarded in their industry, with Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) even owning sizable chunks of the companies.

Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Do your portfolio a favor. Don't ignore the growth you can gain from powerful dividend payers. (%sfr%}