As the S&P 500 has more than doubled off its bottom last year, it has become especially hard for income-oriented investors to identify cheaply valued stocks with attractive dividends.

Canadian bank stocks are a good place to look for undervalued dividend stocks with above-average yields.

Royal Bank of Canada (RY), commonly known as RBC, is a bright example, as it is attractively valued and is offering a generous 3.6% dividend yield.

It will also benefit from the expected hikes of interest rates, which are likely to enhance the interest rate margin of the bank. In this article, we will analyze why RBC is an attractive stock for income-oriented investors.

Photo by Guillaume Jaillet on Unsplash

Business Overview

RBC is the largest bank in Canada by market capitalization and by total assets. It offers banking and financial services to customers primarily in Canada and the U.S.

The key difference of RBC from most banks is its prudent, conservative management, which protects the bank from downturns and results in a consistent growth record. In the Great Recession, the worst financial crisis of the last 90 years, numerous banks incurred excessive losses and were forced to cut their dividends. That was not the case for RBC, which exhibited resilient performance and maintained its dividend in that crisis.

RBC has proved resilient in the coronavirus crisis as well. It incurred a benign 10% decrease in its earnings per share last year and has recovered strongly this year. In the most recent quarter, the bank grew its adjusted earnings per share 19% over the prior year’s quarter, primarily thanks to the strong recovery of the economy, which resulted in a reversal of the loan loss provisions of the bank. Notably, in the full fiscal 2021, which ended in October-2021, RBC grew its earnings per share by an impressive 44%, from $6.04 to a new all-time high of $8.68. Thanks to its sustained business momentum, we expect the bank to post record earnings per share of approximately $8.73 in fiscal 2022.

Moreover, the financial regulator of Canada recently loosened its restrictions and allowed Canadian Banks to resume raising their dividends. As soon as this occurred, RBC raised its quarterly dividend by 11%. As a result, the stock is now offering a 3.6% forward dividend yield. Given the healthy payout ratio of 44% and the resilient business model of the bank, its dividend has a wide margin of safety.

Growth Prospects

Thanks to its conservative business model, RBC has consistently grown its earnings per share. During the last decade, the company has compounded its earnings per share at a 6.3% average annual rate. Moreover, the bank is likely to benefit significantly from the expected hikes of interest rates now that the global economy is recovering from the pandemic. The management of RBC expects to grow its earnings per share by approximately 7% per year on average in the upcoming years. Given the reliable growth trajectory of RBC and its positive outlook, it is reasonable to expect the bank to grow its bottom line as per its guidance.

Valuation – Expected Return

Based on our forecast for earnings per share of $8.73 in 2022, RBC is currently trading at a forward a price-to-earnings ratio of 12.1. This valuation level is marginally lower than the historical 10-year average price-to-earnings ratio of 12.3 of the stock. If RBC trades at its average valuation level in five years, it will enjoy a 0.3% annualized gain over the next five years. Moreover, we expect annual growth of earnings per share of 7.0%, while the stock also offers a 3.6% dividend yield. We thus expect the stock to offer a 10.6% total annual return over the next five years. This is undoubtedly an attractive expected return, particularly given the rich valuation of the broad market.

Final Thoughts

The S&P 500 has posted 69 record closings in 2021 and thus it has rallied 28% this year. This breathtaking rally has made it challenging for income-oriented investors to pinpoint attractive stocks to invest new funds. RBC is a great candidate for the portfolios of these investors, as it is in a reliable growth trajectory, it has proved rock-solid during recessions and it is offering a secure 3.6% dividend yield, with material dividend raises expected in the upcoming years. Some investors may hesitate to purchase RBC near its all-time high, but the stock remains attractive, even at its current level.