After the Federal Reserve announced it would be capping bank dividends as a result of its annual stress testing, Wells Fargo (NYSE:WFC) said it would trim its current payout of $0.51 per common share in the third quarter. The company said it would announce its new dividend when it reports its second-quarter earnings on July 14.

The big question is, how low will that dividend go?

The front doors of a Wells Fargo branch in a city.

Image source: Getty Images.

Calculating the dividend

For at least the third quarter, the Fed will be limiting banks' dividends to the level of their average net income over the past four quarters (although banks are not allowed to raise the dividend over what they paid out in the second quarter). So the big unknown for now is second-quarter earnings. Here's where Wells Fargo stands going into its second-quarter report next week:

Quarter Net Income (millions)
Q319 $4,610
Q419 $2,873
Q120 $653
Q220 ???

Source: Wells Fargo's SEC filings.

The $653 million Wells Fargo reported in the first quarter came to just $0.01 per share. One reason for the small amount was the billions Wells Fargo set aside to cover potential loan losses; another was the bank's inability to generate significant profits. It's difficult for Wells Fargo to expand its balance sheet because it's right up against the $1.95 trillion asset cap the Fed placed on it in early 2018 following its fake-account scandal. Even though Wells Fargo participated in the Paycheck Protection Program, it will have to forfeit any fees it makes to the Federal Reserve, so it is looking at another quarter of small profits and a high loan loss provision.

According to Yahoo! Finance, the consensus among 24 analysts is that Wells Fargo will report a loss of $0.07 earnings per share in the second quarter. I am also going to assume shares outstanding will be unchanged from the first quarter at about 4.1 billion, because the Fed has also suspended stock buybacks. Using these numbers, Wells Fargo would report a loss of about $300 million in the second quarter. 

Quarter Net Income (millions)
Q319 $4,610
Q419 $2,873
Q120 $653
Q220 ($300) (estimate) 
Average Net Income $1,959

Source: Wells Fargo's SEC filings and the author's estimate.

Based on this assumption, Wells Fargo would be able to allocate $1.959 billion to dividends in the quarter. That's already below the $2.4 billion the bank paid out in total dividends in the first quarter of 2020. But before any dividends can go to common shareholders, the company must pay its preferred stockholders. Preferred dividends in Q1 were $339 million. Assuming the same amount in the second quarter, the total amount of net income applicable to common shareholders would be roughly $1.62 billion.

With 4.1 billion of average common shares outstanding, that's a common dividend of about $0.40 per share, or a roughly 22% reduction from the common dividend paid out in the first quarter.

Lots of variables

I would caution that there are several variables that impact this projection. For one, there is a wide range of forecasts regarding Wells Fargo's Q2 earnings. While the consensus is a loss of $0.07 per share, the low estimate is a loss of $0.61 per share, while the top estimate is a gain of $0.43 per share, which seems absurdly high, but you never know. One investor following Wells Fargo says investors should brace for a worst-case scenario of a 50% dividend reduction.

The preferred dividend amount paid out could also change slightly, as could the number of outstanding shares, which would impact the final common dividend. Or perhaps Wells Fargo decides not to issue the full allowable amount -- although I see this as unlikely, considering the bank's limited ability to generate profits and the value that investors have always placed in the company's high dividend yield. I believe a good estimate is a reduced dividend by about a quarter, but that is heavily dependent on how much the company announces in earnings on July 14.