3 Strong Dividend Yields, but Which Is the Best?

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FirstMerit Corporation , Umpqua Holdings , and Susquehanna Bancshares are, on the surface, very similar dividend-paying bank stocks.

They each are profitable, have total assets between $18 billion and $25 billion, and pay a dividend yield of 3.6%. For investors, any one of these three banks looks like a great vehicle to boost your income portfolio without the baggage of a "too big to fail" bank. 

However, despite being so similar on the surface, each of these banks has its own peculiarities that dramatically changes the investment arguments among the three. Let's dig into the details -- this example centers on bank stocks, but the lessons learned are applicable to any dividend stock in any industry.


Let's start with profits
A company must have sufficient earnings and capital to afford making those regular dividend payments every quarter. The stronger a company's earnings, the safer that company's dividend. 

For banks, the primary metric used to evaluate the strength of earnings is the return-on-assets calculation. It demonstrates both earnings power and efficiency by looking at profits relative to the banks' asset base. 

FirstMerit and Susquehanna Banchshares each reported return on assets of 0.9%, which is in line with the industry average for the second quarter. The FDIC's Quarterly Banking Profile found that medium-large banks like these averaged between 1% and 1.1% across the industry. By this measure, FirstMerit and Susquehanna are doing fairly well -- a positive sign for the dividends.

Umpqua, on the other hand, reported just 0.5% return on assets for the second quarter, well below FirstMerit, Susquehanna, and the industry average.

As a dividend investor, suddenly Umpqua's 3.6% yield doesn't look quite as hot as the others. If the company is struggling to turn a profit at the same level as the industry, it doesn't quite follow that the company could support a dividend yield that's nearly double the industry average around 2%.

UMPQ Payout Ratio (TTM) Chart

UMPQ Payout Ratio (TTM) data by YCharts

Because of the bank's relatively low returns and still high dividend, the payout ratio is high. Currently, Umpqua pays out about 80% of profits as a dividend; that leaves little wiggle room for the bank if earnings dip any lower.

What about capital?
Another consideration is leverage. A bank with higher leverage sits on a more fragile capital base. A fragile capital base makes for a fragile dividend.

Umpqua uses less leverage than either FirstMerit or Susquehanna. Using the assets-to-shareholder equity ratio, each bank's leverage over the past 10 years trends like this:

UMPQ Assets To Shareholder Equity (Quarterly) Chart

UMPQ Assets-to-Shareholder Equity (Quarterly) data by YCharts

None of these banks use excess leverage; in fact, they are all well within or below industry norms. From a dividend perspective, each of these banks look appropriately structured to continue paying the dividend.

Leverage is obviously a risk to the bank's stability, but the exact level of "safe" leverage is a relative concept. A bank with a highly risk-averse portfolio can afford to deploy higher leverage, and inversely a bank with more risky assets should use less leverage. To add context to the relative risk on each of these banks' balance sheets, we can look to the level of non-performing assets each bank has on the books. Non-performing assets are loans that are severely past due, plus foreclosures.

According to each bank's most recent quarterly filings with the FDIC, FirstMerit has non-performing assets of 0.84% of total assets. Susquehanna Bank has non-performing assets at 0.68% of total assets. Umpqua Bank has even less, with just 0.48% of total assets currently classified as non-performing.

The industry average for banks of this size is about 1% of total assets, putting all three of these institutions well below average -- which is a good thing.

Funding growth 
The fundamental question that drives dividend decisions is capital allocation. Is the best use of the company's profits a dividend payment to shareholders? Or perhaps a share buyback makes more sense? Or, maybe the company and shareholders are best served by reinvesting the money back into the company to fuel growth?

So far we've discussed each of these banks' varying levels of profit, which are the fuel that generates the capital we need to pay dividends in the first place. Then we found that each of these banks is reasonably capitalized, meaning that there is an adequately strong foundation upon which the companies operate (and pay out those quarterly checks). Next we need to evaluate each bank's growth rate. 

Using each bank's annualized growth rate for the past 12 months' revenue, another major difference emerges among our three bank stocks.

FirstMerit and Umpqua are growing like weeds at 39% and 23%, respectively. Susquehanna, on the other hand, saw its revenue grow just 0.14% over the same time period.

When 3.6% doesn't equal 3.6%
Here's a quick chart reviewing what we've discovered:

BankReturn on AssetsAssets to EquityGrowth Rate*NPA RatioDividend Yield
FirstMerit Corporation0.9%8.839.0%0.84%3.6%
Susquehanna Bancshares0.9%6.60.1%0.68%3.6%
Umpqua Holdings Corporation0.5%5.923.0%0.48%3.6%

*last 12 months

The first and perhaps only clear conclusion is that even though these banks all have the same 3.6% dividend yields, each has its own strengths and weaknesses that are absolutely critical to the dividend. 

FirstMerit has decent returns, more leverage, and the highest growth rate, but it also has the highest level of problem assets among the three. Susquehanna matches FirstMerit's returns on assets, but the bank is simply not growing. Umpqua's returns are very problematic, even with the company's very conservative leverage and low levels of non-performing assets. 

Which of these dividends is the most at risk? From this analysis, Umpqua's dividend seems the most vulnerable. The bank's return-on-assets metric is very problematic; any hiccup to earnings and the bank could easily be forced to pay out more than earnings just to maintain the current dividend. 

FirstMerit's dividend looks the most attractive to me. The bank's profits are strong, it's growing like crazy, and its current 53% payout ratio is sustainable to pay shareholders and still fund the bank's growth.

At the end of the day, every company has its own unique strengths and weaknesses. The key for investors is to take the time to drill down into these details and make an informed decision. These three banks are very, very similar in many ways; however, upon closer examination, we can clearly see that one 3.6% dividend yield is not the same as another.

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The article 3 Strong Dividend Yields, but Which Is the Best? originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of FirstMerit. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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