Last year, Wells Fargo (NYSE:WFC) slashed its dividend 80% as the Federal Reserve put restrictions on banks' capital distributions during the pandemic. Last month, however, with the economy in much better shape, the Fed announced that as long as large banks pass their annual stress testing later this year, they can resume paying dividends and conducting stock buybacks as they see fit.

Considering that Wells Fargo is flush with excess capital and its earnings are much healthier, I believe the bank will undoubtedly increase its dividend next quarter. By how much? Well, that's a slightly more complex question, but let's investigate.

Historical dividend levels

In the third quarter of 2019, Wells Fargo raised its quarterly dividend to its highest-ever level of $0.51 per share, suggesting an annual dividend of $2.04 per share. At the time, shares of Wells Fargo were trading in a range of roughly $45 to $55. That gave Wells Fargo a dividend yield ranging from 3.7% to 4.5%, which is very strong, especially compared to to that of its big-bank peers. Going by payout ratio, Wells Fargo paid out roughly 55% of its earnings in the third quarter of 2019 in dividends, and a whopping 85% of its earnings in that year's fourth quarter. That is much higher than its big bank peers, which tend to have a dividend payout ratio somewhere between 25% and 40%.

Exterior of Wells Fargo bank building

Image source: Wells Fargo.

But everything about Wells Fargo's earnings has been off since the bank was placed under a $1.95 trillion asset cap in 2018 as punishment for its phony-accounts scandal. The asset cap makes it difficult for Wells Fargo to grow its balance sheet and therefore earnings from loans, which is one of the main ways the bank makes money.

Management in 2019 may have thought that the higher dividend was one way to stand apart from competitors and incentivize shareholders to stick with the bank as it sorted through its regulatory troubles.

Where the dividend could go from here

I think it's fairly obvious at this point that a dividend hike is coming. After the big dividend cut last year, Wells Fargo paid a quarterly dividend of $0.10 per common share, which suggests an annual dividend of $0.40 per share. With the stock recently trading at $43, Wells Fargo has a dividend yield of less than 1%, which is too low. With the bank generating $1.05 earnings per share (EPS) in the first quarter, that equates to a dividend payout ratio of less than 10% -- again, far too low. 

However, figuring out how high the dividend will go next quarter and long-term is a bit more difficult to gauge. In 2009, during the Great Recession, Wells Fargo trimmed its quarterly dividend from $0.34 per share to just $0.05 per share, and the dividend didn't return to its previous level for five years.

The pandemic has been much different than the Great Recession. It hit the economy much more abruptly, and the recovery has not only been much faster, but also apparently much stronger. Plus, banks were not the cause of the pandemic, making dividend hikes and share repurchases less likely to come under political fire. Given these factors, I am cautiously optimistic that Wells Fargo can raise its dividend much faster than it did following the Great Recession.

That said, it may take some time for the bank to return to the high dividend yields and payout ratios of the past. The primary reason for this is because CEO Charlie Scharf seemed to indicate on the bank's most recent earnings call that he thought the bank had been too aggressive with its dividend in 2019.

"We were clearly high relative to, you know, what others were and in terms of what we, you know, probably make sense for us," he said. Furthermore, he seemed to more or less agree with analysts' comments about Wells Fargo returning to a payout ratio in the 25% to 40% range, similar to its peers.

The ultimate dividend hike

At the end of the first quarter, Wells Fargo had $33 billion of excess capital above its regulatory requirement, which is a massive amount. So it has the ability to return to a higher dividend level, although it will likely be repurchasing a lot of stock in the second half of the year and will want to approach the dividend somewhat conservatively so it doesn't have to cut it again if the economy takes a sudden turn for the worse. 

Still, let's assume the bank wants to return to a 25% to 40% dividend payout ratio somewhat soon. Analysts on average expect the bank to report $3.62 earnings per share in 2021 -- although the bank already beat its first-quarter estimates, so let's assume $4 EPS in 2021. To get to a 25% dividend payout ratio, that means Wells Fargo would need to increase its quarterly dividend from $0.10 per share to $0.25 per share, or a $1 annual dividend. A 40% dividend payout ratio would mean increasing the quarterly dividend to $0.40 per share, or a $1.60 annual dividend.

I certainly think Wells Fargo could get to a $0.25 per share quarterly dividend sooner rather than later. But getting to the top end of that payout range will likely depend on a mixture of things, including the bank's stock price, its earnings performance, the economic outlook, and the appetite of Scharf and the bank's board of directors. Based on Scharf's recent comments, he and the board could be more conservative than past management.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.