Banks can be great dividend stocks, and investors need to know which of these two megabanks presents the best long-term opportunity for a dividend investor.
Breaking down future dividend potential
Step one: The tale of the tape
These are two of the largest banks in the U.S., with Bank of America topping out at $2.1 trillion in total assets versus Wells Fargo's $1.6 trillion.
Bank of America reported net income of $168 million in the third quarter, and that includes a gigantic charge resulting from the bank's $5.3 billion settlement with the Justice Department.
Now that Bank of America has hopefully put its litigation woes in the rearview mirror, it is looking forward to truly unlocking the massive profit engine that has been hidden under those massive legal costs. A quick calculation to add back that settlement charge shows just how powerful that profit engine could be: $5.4+ billion in the third quarter alone.
Wells Fargo earned $5.7 billion in the third quarter and remains the most profitable bank in the U.S.
Wells Fargo pays a dividend yield of 2.8% according to data from Yahoo! Finance. On a trailing 12-month basis, the bank has paid out about 33% of its profit as dividends. Bank of America's current dividend is much weaker, driven by an accounting error that forced the Federal Reserve to reject the bank's capital plan earlier this year. As it stands today, Bank of America pays a 1.2% yield, with a trailing 12-month payout ratio of 18% of profit.
Step two: Which bank has a better capital position?
Before a bank can pay a dividend, it must be well capitalized. If the bank isn't sufficiently capitalized, then the money will instead be reinvested into the company to boost capital.
Wells Fargo is currently very well capitalized. The bank reported a Tier 1 capital ratio of 11.16% as of Sept. 30, 2014. Bank of America reported 9.6% for the same period.
The biggest risk to capital is loan losses. The Federal Reserve requires banks with more than $50 billion in total assets to run stress tests to estimate exactly what would happen to capital if the economy were to hit the skids and loan losses were to accumulate.
In 2014, Wells Fargo passed the stress tests, and, as previously mentioned, Bank of America's results are under review after the bank discovered an accounting error that misrepresented its capital levels. In my view, that miscalculation will have a relatively minor impact on the final conclusion.
Even before that miscalculation, though, Wells Fargo handily outperformed Bank of America in the tests.
Bottom line: Wells is a better capitalized bank today and is better prepared to weather an economic storm.
Step three: Consistency
Who wants a company that pays out a handsome quarterly dividend check today, but then cancels the dividend next year for some unforeseen reason?
The short answer is no one.
We want a dividend that's going to pay, and pay, and pay, and pay. Set it and forget it.
For bank stocks, the key to that consistency is making good loans consistently. It's about having a credit culture that puts risk management first. It's about demonstrating a management approach that makes money throughout the business cycle, which means avoiding bad loans when the economy is on fire and making good loans when the economy is on the ropes.
The only way to assess this is to look at historical performance, and in that context, Wells Fargo is the clear winner. For a complete breakdown of these banks' risk management cultures, read here.
So, at the end of the day, here's the breakdown:
Both Wells Fargo and Bank of America are ridiculous profit engines generating billions of dollars in net income every quarter. Particularly now that Bank of America has settled the majority of its legal problems with the Department of Justice.
Both banks are well capitalized, although Wells Fargo has a better capital position today and is projected to maintain a higher level of capital in another recession, according to the Federal Reserve's stress test results.
Finally, Wells Fargo has a far stronger record of navigating through tough economies without accumulating massive losses that could threaten the consistency of your dividend.
Bank of America CEO Brian Moynihan has done a remarkable job of turning the bank around from the lows of 2008 and 2009, but it's just too early to say if he can also successfully change the bank's credit and risk culture.
Therefore, Wells Fargo is the winner by unanimous decision and still bank stock dividend champion of the U.S.