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Discover, Fifth Third Are Well-Positioned for Higher Payouts After Stress Tests

NEW YORK (TheStreet) -- Discover Financial Services (DFS - Get Report) and Fifth Third Bancorp (FITB - Get Report) should be very well-positioned for higher payout ratios following the Federal Reserve's stress tests and capital plan reviews, according to Janney Capital Markets analyst Sameer Gokhale.

The Federal Reserve will announce the results of its annual stress tests on March 20.  The stress tests will gauge 30 large bank holding companies' ability to remain well-capitalized, with minimum Tier 1 common equity ratios of at least 5% through a "severely adverse" economic scenario.

This year's scenario assumes an increase in the U.S. unemployment rate of four percentage points, with the unemployment rate peaking at 11.25% in mid-2015. The scenario also includes a decline in real U.S. GDP of nearly 4.75% through the end of 2014, a 50% decline in equity prices and a 25% decline in home prices.

Then on March 26, the Fed will announce the results of the annual Comprehensive Capital Analysis and Review (CCAR), through which the regulator incorporates banks' plans to deploy excess capital through dividend increases, share buybacks and acquisitions.

Must Read: Banks' Excess Capital Is 'Absolutely a Reality'

Please see Banks' Excess Capital Is 'Absolutely a Reality' for a discussion on why most of the banks subject to the stress tests and CCAR are expected to pay out a significantly higher percentage of earnings this year than they did during 2013.

According to Gokhale's estimates, Discover and Fifth Third will come though the stress tests showing respective minimum Basel III Tier 1 common equity ratios of 8.95% and 7.30%.  "We believe that FITB and DFS should be able to justify higher payout ratios because they should have higher capital ratios than the fully phased-in 7% Common Equity Tier 1 ratio under the severely adverse scenario," Gokhale wrote.

The "fully phased-in" minimal Tier 1 common equity ratios for Discover and Fifth Third don't need to be achieved until January 2019.  This means that both banks could afford to deploy significant amounts of capital to investors, even through the Fed's gloomy stress-test scenario.

Discover and Fifth Third "should also have the highest payout yields of approximately 8.6% and 6.2% respectively," Gokhale wrote.  By "payout yield," the analyst means the total annual deployment of dividends and cash for share buybacks, divided by the share price. 

Gokhale explained further: "We believe that the payout yield represents a key component of the return on invested capital from an investor's standpoint. We believe that the payout yield is even more important than the payout ratio because the payout ratio can be driven up by lower net income available to common shareholders. Therefore the payout yield should be more indicative of a return on investment."

Discover's shares closed at $59.41 Monday and traded for 10.7 times the consensus 2015 earnings estimate of $5.33 a share, among analysts polled by Thomson Reuters. That's a rather low forward price-to-earnings ratio when considering that the company's 2013 return on average tangible common equity (ROTCE) was was 25.26%, following a 26.82% ROTCE in 2012, according to Thomson Reuters Bank Insight

Gokhale's expected range of Discover's quarterly dividend following CCAR is 21 cents to 23 cents, increasing from the current 20 cents. He expects Discover to receive regulatory approval for share buybacks ranging from $1.1 billion to $1.5 billion, form the second quarter of 2014 through the first quarter of 2015.

Fifth Third closed at $22.70 Monday.  The shares trade for 11.9 times the consensus 2015 EPS estimate.  The company's 2013 ROTCE was 16.46%, increasing from 14.43% in 2012.

Gokhale's estimated range for Fifth Third's quarterly dividend following CCAR is 12 cents to 15 cents a share.  The current dividend is 12 cents.  The analyst estimates Fifth Third will be approved for between $1.1 billion and $1.3 billion in share buybacks.

Shares of Discover were down 1% in afternoon trading Tuesday, to $68.81, while Fifth Third was down 0.8% to $22.51.

Gokhale has "buy" ratings on both stocks.

This table shows the stock performance for Discover and Fifth Third against the KBW Bank Index and the S&P 500 since the end of 2011:

DFS Chart data by YCharts

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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