MOOSE MARKETS

INVESTING THE CANADIAN WAY

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High-Income Products: Making Life Easier?

Are high-income products really making life easier for retirees? Investing $100K in something giving back $800/month, a 9.6% yield, is appealing for retirees. Financial companies even say, “no need to worry about the unit price as long as you receive your payment”. If you get your monthly paycheck, why be concerned? Well, you should.

Child crossing stream on logFinancial companies, like asset managers, make fees based on the amount of Assets Under their Management (AUM). The higher the AUM, the higher the revenue and profit. Retirees are very profitable customers for these companies because of their sizeable savings, often in the hundred of thousands, that make growing AUM a lot easier than millennials investing much less. What do retirees want? Income!

When stock dividend yields are low, and interest rates on certificates of deposit, GICs, and bonds are low, how are financial companies able to generate additional income from their products? Often, with options and leverage strategies.

Using derivatives, they write covered call options and cash covered put options, or purchase call options. You put your cash in a black box, the firm shakes it a bit and pays you back. Often these strategies are fraught with risks. Consider the following points when contemplating these products.

Learn strategies for generating income for life. Download our guide now.

Understanding the strategy

Read the fine print to understand the strategy, Picture of a Magnifying glassFinancial companies often use a mix of options strategies to create income; you must understand what you’re investing in. You’ll have to read pages of boring stuff, and don’t stop at the description either!

From Financial Split (FTN.TO)’s description: “…is a high-quality portfolio consisting of 15 financial companies made up of Canadian and U.S. issuers”. With a 13.5% yield, it sounds promising. Further, you find this in their 2022 annual information form:

“Up to 15% of the net asset value of the Company may be invested in equity securities of issuers other than the Portfolio Companies.”

And: “To supplement the dividends earned on the Portfolio and to reduce risk, the Company will from time to time write covered call options in respect of all or part of the Portfolio.”

It goes on to mention writing cash covered put options or purchasing call options, purchasing put options to protect itself from declines in the market, trading to close out positions, using derivatives for hedging purposes, etc.

In English: on top of what’s in the portfolio, there could be 15% of “mystery” equities. It’s up to option strategists to work their magic to generate astronomical income.

How did FTN.TO work out for investors? Well, the monthly distribution remains unchanged since 2008. Oh, it skipped 34 monthly payments between September 2008 and December 2020, including 18 consecutive months starting in 2012 (source). So, not well at all.

These complex options strategies might work, or not. They do well when the market is moving up, not so much when things get volatile. From what I’ve observed, I feel that these aren’t products to expose your hard-earned savings to at all.

Learn strategies for generating income for life. Download our guide now.

Leaving money on the table?

I understand wanting income in retirement, but don’t neglect total returns; if you do, you might leave a lot of money on the table. Imagine investing in a new High Income DSR fund requiring a minimum 100K investment and starting with 9% yield.

Over time, you notice that while you’re getting your 9% yield, your 100K isn’t keeping up in value. Total return (capital gain + dividend) is still positive, but you didn’t make the money you would have with a classic index ETF. How would you react?

In my opinion, the value of your portfolio is just as important as the money you receive monthly. Compare the total return of high-income products with a benchmark (index fund, dividend ETF) to see how they measure up to the total return you’d get from more traditional investments.

Comparing apples to apples

To judge high-income products correctly, you must compare them to appropriate benchmarks. The returns for Canoe EIT income fund (EIT.UN.TO) show that, over 10 years. it beat the TSX consistently.

Table showing Canoe Income Fund returns versus those of the S&P/TSX Composite Index over 1 month to 10 years and since inception. It shows Canoe outperforming the index throughout.

Beating its benchmark and a yield >9%? Perfect for retirees. Or is it? The EIT fund profile, shows 43.4% is invested in U.S. equities.

Pie chart showing the Canoe Income Fund's asset mix: 54.4% Canadian equity, 43.4% US equity, 2.5% International equity, and 0.7% in fixed income.

Therefore, the correct benchmark is a mix of Canadian, US, and international indices, not the TSX index.

To compare apples to apples, I used a portfolio containing a mix of index ETFs that mirrors EIT’s asset mix: 54.4% XIU.TO for Canadian equity, 43.4% SPY for US equity, and 2.5% XEF.TO for international equity. The red line shows this index ETF portfolio’s total returns, including dividends, as of 7/31/2023.

Line graph showing total returns for Canoe Income Fund and custom index-EFT mix that is a more appropriate benchmark than the TSE index.

The index ETF portfolio 5-year return of 60.19%, or 9.88% annualized, is much lower than EIT.UN.TO at 13.5% annualized. However, Canoe didn’t consistently exceed the index ETF portfolio over 10 years; actually, EIT.UN.TO returns were equal to or below indices until 2021 when it surged ahead.

This is thanks to the management team’s superb job in positioning the fund portfolio to surf the energy boom in 2020. In 2022, the energy sector was one of very few sectors in positive territory, the S&P 500 closely resembled a bear market, and Canoe beat relevant indices.

While Canoe doesn’t use the correct benchmark to show its merit, the fund does generate strong results. However, between 2013 and 2019, it was barely better than the TSX. A single move, going massively into oil & gas, made a huge difference.

Learn strategies for generating income for life. Download our guide now.

In closing

Not all high-income products are terrible. In fact, Canoe has a pretty good overall performance. Comparing it to Financial 15 Split Corp (FTN.TO), with its complex strategy and poor results, clearly shows how the management team can make a huge difference.

The Canoe fund could be interesting to generate a high income but, looking at the graphs below, keep this in mind: 1) your capital likely won’t grow over time and 2) neither will your dividend.

Line graph showing Canoe Income Fund unit price change and dividend change for 10 years up to 2023. Reveals not appreciating in value and dividend payment is flat.
Where’s the growth?

You’re still better off with a classic investment strategy that generates a higher total return. You can sell a few shares to create your own retirement income. See Generate Enough Retirement Income from Your Portfolio.

Next week, more on high-income products: split-share corporations and covered call ETFs. Stay tuned…

Puzzled about Old Age Security (OAS)?

How is Old Age Security (OAS) different from the Canada Pension Plan (CPP)? Who is eligible for OAS and what is the benefit amount? How does one apply for OAS benefits? What is this OAS claw back you’ve been hearing about? So many questions, so little time. Look no further, here are the answers, in a nutshell.

What is Old Age Security (OAS)?

Old Age Security (OAS) is a taxable monthly payment the federal government gives Canadian residents and/or citizens who meet the eligibility criteria, once they are 65 years old or older.

How is OAS different from the Canada Pension Plan (CPP)?

Orange maple leaf held up to the daylight in the forest in the fallUnlike the Canada Pension Plan (CPP) and the Quebec Pension Plan (QPP/RRQ), the OAS is not a pension to which you and your employer(s) contribute over the years. OAS payments come from the taxes the federal government collects each year.

Another key difference is that OAS payments are not based on how long people have worked or how much money they earned. OAS benefits are paid to every eligible citizen or legal resident, even if they never received employment income.

Want to know more about the CPP/QPP? See Explaining the Canada Pension Plan (CPP).

Who is eligible to receive OAS?

You are eligible to receive OAS payments if:

  • You are a Canadian citizen or legal resident.
  • You are 65 years of age or older.
  • You currently live in Canada and have resided in Canada for at least 10 years since the age of 18, or you don’t currently live in Canada but have done so for at least 20 years since the age of 18.

There are rules for other situations; for example, if you lived outside Canada while working for Canadian employers, or if you have contributed to other countries’ social security programs.

How much will I receive in OAS payments?

View from the top of the horseshoe-shaped falls in Niagara Falls, OntarioThe amount of the OAS payment depends on how long you have lived in Canada since the age of 18, and the age when you start receiving the payment. Your OAS monthly payment increases by 10% when you turn 75 years old.

The amount of the OAS benefit is reviewed and updated four times a year to adjust it for the cost of living.

Surely there is a maximum OAS payment…

Right you are! As of June 2023, the maximum OAS payment is $691 per month ($760.10 per month for people 75 and older).

The maximum payment is paid to people who lived 40 years in Canada after the age of 18, and who have a net income that is below a specific threshold for the calendar year prior to the payment. More about that later.

Find out how to get an estimate of your OAS benefits, download our guide now.

How do I apply for OAS?

Most eligible Canadians do not have to apply to start receiving OAS payments; when you get close to the age of 65, you’ll receive a letter from the government indicating when you will start to receive OAS payments. However, if you decide to delay receiving your payments, you must notify the government.

Delay the start OAS payments! Whatever for?

Hip looking senior women, short white hair, red leather jacket, bulky jewelry and sunglasses with cheeky smileYou can delay receiving OAS payments until the age of 70. For every month after your 65th birthday that you delay receiving your first OAS payment, the government increases the amount you will receive by 0.6%, or 7.2% per year.

Once you start receiving OAS payments, you cannot change your mind; in other words, you cannot pause the payments to delay to a later age and receive a higher payment.

What is the OAS claw back?

The purpose of the OAS is to provide some financial protection and reduce poverty in old age. OAS recipients who have enough income from other sources to live comfortably must pay back some or all of the OAS payments they receive. This is often called the OAS claw back; the government calls it a recovery tax.

What is the income level at which
I have to pay back some of my OAS?

As of July 1st, 2023, if your net income is below $81,761, you do not have to pay back any of the OAS benefits you receive in 2024. For incomes above that threshold, the amount to pay back is 15% of the difference between your net income and $81,761. The income threshold is updated yearly.

What is considered income for the OAS claw back?

Income includes work income, pensions, CPP payments, withdrawals from RRSPs, and dividends, capital gains, and interest earned from non-registered investments.

Download our guide to get tips for choosing when to start receiving OAS payments, and more information.

What do I need to do about OAS?

  1. Decide at what age you want to start receiving OAS payments.
  2. Before you turn 65, you will receive a letter from the government letting you know when to expect your OAS benefits, and the amount you will receive.
    • If you want to start receiving OAS at 65, and all the information in the letter is correct, you don’t have to do anything. If there are errors in the letter, you will have to contact the government.
    • If you want to delay the start of the OAS payment, you will have to notify the government before you turn 65.

Why does the Government of Canada pay OAS benefits?

Side by side headshots of James S. Woodsworth and Abraham A. Heaps
L to R: James S. Woodsworth and Abraham A. Heaps

We can thank two labour party MPs, James S. Woodsworth and Abraham A. Heaps, both from Winnipeg. In 1925, they accepted to support prime minister Mackenzie King’s minority government in exchange for his promise to, among other things, create old age benefits.

At the time, many seniors were living in poverty. The jobs they had relied on to earn a living were disappearing as industrialization profoundly changed how goods were produced. Younger workers who were supporting their aging parents struggled to save money for their own old age.

Although Mackenzie King resigned before creating the old age benefit, he was re-elected in 1926, this time with a majority. He kept his word. The Old Age Pensions Act came into effect in 1927.

 

 

Explaining the Canada Pension Plan (CPP)

You’ve heard about the Canada Pension Plan (CPP), you see it on your income tax slips, you’ve paid into it. You know the CPP is a benefit you can start to collect in your 60s. Still, you might be a little hazy on the details.

  • How much does the CPP pay?
  • Who is eligible to receive CPP payments?
  • Is it taxable?

You’ve also heard some people start to collect CPP when they turn 60 while others wait until the age of 70. Why? When is the best time to take it?

If you live in Québec, or have worked in Québec, you might have heard about the Québec Pension Plan (QPP, or RRQ in French). Is that different from the CPP?

Want to demystify the CPP? We do too. Here it is.

What is the Canada Pension Plan (CPP)?

Created in 1965, the Canada Pension Plan is retirement benefit payable to Canadians who have earned employment income and have paid contributions to the CPP. It was created to address growing poverty among retired Canadians.

Child with his back to us, standing in a park with the Canadian flag draped over his shouldersThe CPP is funded by contributions made by Canadian workers and their employers. The contributions are a percentage of the employees’ salary, up to a maximum yearly contribution. The employee contributions are withheld from the workers’ pay by employers. The Canada Pension Plan is one of the largest pension funds in the world.

The CPP covers all Canadian workers except those in Québec who are eligible for the equivalent Québec Pension Plan (QPP), also known in French as the RRQ.

Another retirement benefit for Canadians is Old Age Security. Read all about it here next week.

How much does CPP pay?

The amount of your monthly CPP payment depends on how long you have contributed to the Canada Pension Plan, how much you’ve paid into it, which is based on your salary, and at what age you begin to collect CPP.

As of January 2023, the maximum monthly payment someone can receive, when starting at age 65, is $1,306.57. The average monthly payment for people starting to receive CPP at 65 is $811.21.

You can see an estimate of the CPP amount you’ll receive, based on your contributions to date, on the Government of Canada website. If you are a Québec resident, you can see an estimate of your QPP on the Government of Québec website.

Download our CPP & OAS Guide right now for easy instructions for accessing your estimate.

Who is eligible to receive CPP payments?

Anyone who has contributed to the Canada Pension Plan during their life. You can begin receiving the CPP payment as early as age 60, and at age 70 at the latest.

Is the CPP payment taxable?

Yes, it is. There’s always something, isn’t there? For some help on that front, read our Retirement Tax Optimization Basics article.

Do the payments change over time for inflation?

The CPP payment is adjusted once a year, in January, based on the Consumer price index (CPI) All-Items Index.

Some people begin to receive CPP payments at 60, while others wait beyond age 65. Why?

The age at which you start receiving CPP affects the amount you receive. To make the decision, consider your retirement plans, health, and financial situation.

Taking CPP early, meaning before age 65, means your payment is reduced from what it would have been at age 65, by 0.6% for each month before your 65th birthday at the time you start receiving it.

Moose standing on a snowy road in the forest sniffing the groundFor example, if you begin receiving the CPP when you turn 63, which is 24 months before your 65th birthday, your payment is reduced by 14.4% (24 months * 0.6%) from what you would have received had you waited until your 65th birthday.

On the other hand, if you delay receiving the CPP beyond age 65, the payment you receive increases by 0.7% for each month you delay. So, someone who begins receiving CPP when they turn 69, four years after turning 65, receives 33.6% (48 months * 0.7%) more than they would have at age 65.

Once you start receiving CPP payments, you cannot cancel. The payment you receive is set and will not change, other than the yearly review to account for the cost of living. In other words, there is no do-over; you can’t stop the payments and delay them to a later age to receive a higher amount.

Want to know more? Download our CPP & OAS Guide.

Why take CPP early?

Reasons for taking the CPP early include needing the income sooner than age 65, and having good reasons to believe you will not live to age 80, such as current health issues, lifestyle, or family history.

Senior citizens enjoying a sunny day at oceanfront beachSome people take CPP early to have more money to enjoy life while they are young and active retirees; this can be the right choice, as long as they have enough savings or another pension to rely on in their later years to make up for their lower CPP amount.

Who delays receiving CPP?

People who have significant savings, another pension plan, or both, as well as those who plan to keep working part of their 60s might also prefer to delay receiving CPP. In doing so, they’ll get a larger amount and better financial protection should they live to a very old age.

Remember, delaying receiving CPP to a time when your income will be lower also reduces the amount of tax you’ll pay on it.

 

Retirement Tax Optimization Basics

Tax optimization is an important aspect of retirement planning. Beyond saving, investing, and accumulating wealth, examine how you can reduce the amount of tax you pay when retired.

Canadian currency, bills and coins, on white backgroundThis article doesn’t go deep into tax issues because each situation is different, with different applicable rules and tax rates. However, there are situations we all have in common upon retirement. After your retirement strategy is outlined, i.e., your global asset allocation, risk tolerance, types of investments, etc., you’re in a good position for some tax tweaking. Don’t do it the other way around.

Why do I believe one should perform tax optimization only after you have set your investing strategy? Because while it’s good to trim your tax burden, you should not do it at the expense of the bigger picture. In other words, I don’t think it’s all that bad to pay withholding taxes on dividends received if it enables you to have a more diversified and better performing portfolio.

See also Create your own Paycheck in Retirement

However, when it’s time to retire, the order and timing of withdrawals can greatly affect your budget. You can’t control your portfolio performance, but you can control a part of the taxes you’ll pay, or save, at retirement. Therefore, crunching numbers with a tax expert is likely to make a big difference in your lifestyle.

Canadians, learn about government retirement benefits.  Download our CPP and OAS guide.

My take on tax optimization

I’m not a tax expert, but after doing hundreds of financial plans for my clients as a financial planner back in my banking days, here are my conclusions.

First, know that there are no magic tricks for optimizing taxes. Any strategies viewed as “too aggressive” by regulators will be rejected and you’ll get a slap on the wrist

Two women talking while sitting at office table in front of brick wallThe best tax advice I can give you is quite simple: spend a few thousand dollars with a fee-based financial planner and an accountant. They’ll do the hard work and offer you a customized plan to optimize your taxes. Make your appointment, develop a plan, and avoid potentially costly mistakes.

To know more ahead of consulting an expert, or if you want to skip consulting and do it yourself, learn about the simple 3 Ds of tax optimization: Deduct – Defer – Divide.

Deduct: maximize deductions, reduce your taxable income

Anything you can use to reduce your taxable income automatically lowers your taxes, especially if you live in a country with increasing marginal tax rates like Canada. Examples of deductions you can use to reduce your income at any age include contributions to your retirement plans, interest paid on loans used to procure non-registered investments, and healthcare expenses.

Defer: postpone paying taxes as long as you can

Here’s a tip for my Canadian readers (I’m pretty sure it applies to Americans too, but you should verify this first). It sounds counter-intuitive, but in most cases, deferring the moment when you withdraw money from your tax-sheltered account (such as your RRSP account) is worth it. Here’s why.

The longer you wait to withdraw money from a tax-sheltered account or to trigger capital gains, the longer your money is growing tax-free. At retirement, it’s usually preferable to let your tax-sheltered account grow while withdrawing money from regular investment accounts, if possible. Remember that all investment income coming from a taxable account, whether it is withdrawn or reinvested, is income in your tax declaration.

Plant growing in clear glass pot filled with coinsSome retirees are tempted to withdraw money from tax-sheltered accounts earlier to pay less tax, as they assume their marginal tax rate to be lower at 60 years of age than at 85, when they anticipate they’ll have to withdraw more money. However, when you withdraw money, you pay the taxes immediately. The money paid to the government can’t compound going forward. Withdrawing at a younger age means you miss out on years of growth on tax paid.

For example, if you need $7,000, you could sell shares in a taxable account and pay a small amount in capital gains. Perhaps you’ll have to sell for $7,500 to receive $7,000 net of taxes. You could also sell for $10,000 in your RRSP to receive $7,000 after taxes. That extra $2,500 paid in taxes won’t compound tax free inside your RRSP for the next 20 years. At a 7% investment return, each $2,500 turns into $9,674 in 20 years from now. That’s almost 4 times the original amount!

Divide: divide your income with a spouse

Two cedar waxwing birds on a branch, with one giving a berry to the other

You can split assets or income sources with your spouse to keep each of your incomes in a lower marginal tax rate brackets. You’ll pay a lot less in tax if you split $100K of income 50-50 than keeping it solely under your name.

 

Tax optimization take away

Unfortunately, there are no secret ways to make taxes disappear, other than those usually referred to as fraud or evasion. If you’re Canadian and dislike the OAS claw back, look at it this way: being asked to payback some of the OAS benefits you received is a good problem to have; it means you likely have plenty of money to enjoy your retirement.

Canadians, learn about government retirement benefits.  Download our CPP and OAS guide.

An accountant can do a great job at drawing up a plan to optimize your taxes; the best way to approach tax optimization is to run multiple scenarios and see the impact of each choice. Don’t forget to always focus on your investment strategy first. Saving money in taxes is great, but making higher total returns is even better! Adding risk or reducing total return for the sake of taxes isn’t a good idea.

Retirement Cash Reserve: Surf the Market’s Waves

Having a cash reserve on-hand makes it easier to transition from your investment accumulation years to your retirement years and protects your portfolio during times of volatility.

Upright polar bear with one paw up, as if wavingThroughout your retirement, you’ll go through bull and bear markets. During a bear market, selling shares to generate your homemade dividend could hurt your retirement plan.

That’s when the cash reserve helps; it’s money that is not invested in the stock market anymore. It must be secure and easily accessible.

How to use the cash reserve

Your cash reserve bridges the gap between what your portfolio generates in dividends and your retirement budget; it prevents having to sell shares when it is not advantageous to do so.

If you need $50,000 per year and your portfolio generates $40,000, the gap is $10,000 per year.

The $10,000 gap could be filled by selling shares. Selling shares at a depreciated value could hurt your retirement, whereas dipping into a cash reserve keeps your portfolio intact. When the market recovers, you can sell additional shares to refill your cash reserve.

How much cash reserve is enough?

There’s no clear answer to this question. You want to mitigate the impact of market volatility on your withdrawal sequence, but you also want to maximize your portfolio returns.

A large cash reserve increases the short-term protection of your withdrawals but amputates your portfolio’s ability to generate higher returns on the market over the long haul.

Therefore, the amount of the cash reserve depends on the gap to fill and your tolerance to volatility. Some investors are comfortable without any cash reserve; they simply accept that they will sell shares yearly to complete their retirement budget, regardless of how the market is doing.

Others prefer a large cash reserve to cover all potential catastrophes. While most bear markets take around 24 months to recover, some have taken more than four years to fully recover.

Get some great stock ideas to build your portfolio and cash reserve with our Rock Stars List 

DOWNLOAD THE LIST HERE

Create a cash reserve

To create a cash reserve, you can stop reinvesting your dividends a few years before retiring and let the cash build up in your account. It’s on autopilot, simple, but it could take a few years to reach the required amount; during that time, the cash doesn’t generate any meaningful returns.

To let your portfolio work at full speed until the very last moment, you could sell one- or two-years’ worth of your financial needs in shares on day 1 of your retirement. However, if you retire at the bottom of the market, you’d be selling at a very bad time.

Cash reserve example

Imagine you have a $1M portfolio, an average dividend yield of 3.5%, and a retirement budget of $50,000/year. Since the portfolio generates $35,000 in dividends ($1M X 3.5%), the gap between what you generate and what you need is $15,000.

To ensure you don’t have to sell shares during a bad year, you decide to create a cash reserve of four years’ worth of the $15,000 gap, so $60,000.

Create and manage the cash reserve

In this example, a few years before start of your retirement, you stop reinvesting your dividends to let them accumulate. A year before your retirement date, you have your $60,000 cash reserve on hand.

You manage your cash reserve through a three-year ladder of Guaranteed Investment Certificates (GICs), Certificates of Deposit (CD), and/or bonds that would look something like this:

  • Three piles of golden coins, from small to large$20,000 for 1 year at 3%
  • $20,000 for 2 years at 3.25%
  • $20,000 for 3 years at 3.30%

You also keep accumulating your dividends in cash rather than reinvesting them.

At the end of the year, you retire

As you retire, your 1-year GIC/CD is worth $20,000 + $600 (one year of interest). Since you stopped reinvesting your dividends 12 months ago, you’ve also accumulated $35,000 in dividends ($1M X 3.5%).

Income on hand for year 1 of retirement

GIC/CD with interest $20,600
Dividends + $35,000
Total $55,600
Budget ($50,000)
Difference  + $5,600

You reinvest that extra $5,600 for another 3 years to feed the ladder and keep it going.

If it’s a good year and your portfolio is up, you sell shares to have just enough money to “refill” your bond ladder. Then you have another $20K to invest for 3 years. With the extra $5,600 on hand, you only have to sell $14,400 of shares to reach $20K and complete the ladder.

Notice that $14.4K on $1M equals a 1.44% capital gain. On most years, you’ll be able to do that easily without chipping away at your capital.

What if the market is bad?

If it’s not a good year and your portfolio is down, you can easily wait 6 months or a year and see where the market is at that time before selling shares. Really?  Yes, because you already have your income for the year and, at the end of year 1, you’ll have this on hand for year 2 of retirement:

2-year GIC/CD with 3.25% interest $21,321
One year of dividends* + $35,000
Total $56,321
Budget ($50,000)
Difference  + $6,321

* This is the same amount as the previous year; by investing in dividend growers, it is likely that some of your holdings increased their dividends, so this could be higher.

If at the end of year 2 of retirement the market is still bad, you still have your 3-year GIC/CD worth $22,046, and another 12 months of dividends from your portfolio.

Of course, waiting to sell shares during a bad spell in the market means that eventually you’ll have to sell more to refill your cash reserve ladder.

Retired couple walking toward the sea in Eastbourne on sunny day

Considering that most crashes happen over a few months or a year, after which the market starts recovering, and that the cash reserve ladder ensures you have over two years of buffer, you’ll be in a good position to refill the ladder using only or mostly your capital gains and dividend increases, thus securing your retirement for year to come!

DDM Stock Valuation to Compare Stocks

One of the most debated topics among investors is how to assess the value of a stock. I like to use stock valuation models like the Dividend Discount Model (DDM) to compare similar stocks I have already thoroughly analyzed and find interesting, to see which one might be the best deal.

I don’t use valuation to determine if the company is undervalued or not because, to be honest, your guess is as good as mine. If you put ten financial analysts in a room and ask them to determine the valuation of a company, you’ll likely end up with ten materially different answers.

They’re all smart folks, but each of them has a different perspective. However, using a valuation tool with the same perspective and applying it to two or more companies in the same sector makes it easier to identify which one is the best deal and the best fit with my investment thesis.

To clarify this process, let’s compare two Canadian banks: Royal Bank (RY.TO) and National Bank (NA.TO).

Analyzing RY.TO and NA.TO

Before looking at the fair value of Royal Bank and National Bank as per the DDM, any investor interested in them should analyze both; study their business model, look at their dividend triangle, evaluate the safety and growth potential of their dividend, identify their growth vectors and their risks. For details about what I do to analyze stocks, read this article.

Our diligent investor might summarize the analysis like this:

Business model:

  • Both RY and NA are regulated and diversified Canadian banks
  • RY is much larger than NA ($181B market cap vs. $35B)
  • RY is more distributed geographically than NA, which is heavily concentrated in Quebec

Dividend triangle, dividend safety and growth:

  • Both banks have a strong dividend triangle showing growth in revenue, EPS, and dividend
  • NA shows slightly faster dividend growth since early 2022 and higher growth numbers over 5 years for all three metrics
  • Dividend payout ratios are under control for both, with RY near 45% and NA near 37%

Growth vectors:

  • RY has diversified revenue streams and is increasing its activities outside Canada
  • RY targets growth in wealth management, capital markets, and insurance, with this trio already representing over 50% of its revenue
  • NA follows a growth by acquisition strategy, targets wealth management and capital markets
  • NA is more flexible and quicker to move due to its smaller size

Risks:

  • RY capital markets and insurance growth vectors are inclined to variable returns
  • RY has high exposure to Canadian housing market and the effects of rising mortgage rates
  • NA is dependent on the Quebec economy, although it has been expanding with private banking in western Canada and investments in emerging markets, such as the ABA bank in Cambodia
  • NA takes more risks to find growth vectors

DOWNLOAD THE LIST HERE

With all this analysis information on hand, our investor still hesitates between Royal Bank and National Bank and now turns to the DDM valuation to compare them.

Comparing NA.TO and RY.TO Valuation

Here is the DDM valuation data for both Royal Bank and National Bank taken from their respective stock cards on the DSR website.

DSR DDM values for RY.TO and NA.TO with intrinsic values circled in red

At the time of writing, National Bank was trading at about $103 per share and Royal Bank at around $131.00 per share.

Looking at this data to compare both banks, including the value circled in red for each bank, observe the following:

RY NA
DDM Intrinsic value $190.80 $99.77
Current stock price $131 $103
Stock currently trading at 45% discount 3% over its value

At 45% discount, RY looks like an amazing deal, a slam dunk, right? It certainly does, but…there is a crucial difference to understand here, which is the discount rate. The discount rate, also known as the “expected return”, represents the minimum acceptable rate of return that an investor expects to earn on their investment to compensate for the risk and opportunity cost of investing in that particular stock.

Compare Apples to Apples

Notice below that the discount rates used for the intrinsic value of RY and NA are not the same. Due to RY’s geographic distribution and revenue stream diversification mentioned earlier, we used a discount rate of 9%, whereas NA’s more audacious approach made us use a 10% rate.

DDM values for RY.TO and NA.TO with values for the same discount rate circled in red

If we compare both banks with the same discount rate of 10%, we see that the difference between the two is significantly reduced.

  RY NA
DDM Intrinsic value $143.10 $99.77
Current stock price $131 $103
Stock currently trading at 9% discount 3% over its value

If you hesitate between RY and NA, a look at the DDM value confirms that your dilemma is between two really good stocks. RY might seem a better deal at current prices, but NA could be a better pick if you want more growth potential and are prepared to live with more volatility in the stock price.

I have both Royal Bank and National Bank in my portfolio because both fit my investment thesis. I appreciate National Bank’s significant growth potential and Royal Bank’s more stable and steady approach. As a reliable source of income that also shows growth vectors, RY.TO is also included in the DSR Canadian retirement portfolio model.