These 8 Bank Stocks Could be Tomorrow’s High-Yielders

Many of the big U.S. banks have already reported their financial results for 2011. The overall reports were quite impressive, considering that just three years ago there were major concerns that a number of them wouldn’t be able to survive the credit crisis.

The recent financial reports demonstrate that bank profits have largely recovered to pre-crisis levels and are set to expand in the next few years by as much as 10% annually. The largest banks are now sitting on billions dollars in exces(s cash and are ready to start returning it to shareholders as soon as they get the green light from the Federal Reserve. (After the U.S. government bailed out the financial sector during the height of the credit crisis in late 2008, one of the Fed‘s first decisions was to reduce or eliminate dividends of banks in order to preserve capital.)

Historically, bank stocks have been great dividend-paying investments. The current recovery is proving that the credit crisis was a major anomaly in a growth and income track record that has been impressive in the long term.

With the financial sector being more consolidated and demonstrating an ability to conduct business more carefully, the Fed should start to allow dividend payouts to rise again this year. I fully expect this to occur at the stronger banks, which have shored up their capital bases and have demonstrated their ability to make sound business decisions.

In the table below, you’ll see what the dividend payout ratios were for the nation’s leading banks prior to the credit crisis. I believe this is a fair representation of the percentage of earnings these banks will be capable of paying out as dividends once they receive the go-ahead from the Fed.

On average, banks had dividend yields between 3% and 4% prior to the crisis. As you can see, the average yield for these eight banks prior to the credit crisis was pretty appealing at 3.7%. And, on average, these banks paid out half of their reported earnings as dividends.

Based on the 2011 earnings and payout figures, the payout ratio and dividend yields for these banks have fallen dramatically. Currently, they are paying out less than 18% of their earnings as dividends. This works out to 1.7%, which is well below historical levels and what these banks are capable of paying out.

By simply estimating that banks will eventually be able to pay out 50% of earnings as dividends again, the calculation shows they have the capability to more than triple their current payout rates. Because earnings have recovered and even started to exceed pre-crisis levels, there is the potential for dividend yields well above 5%. On average, the yield could rise to 5.5%, which would be quite reasonable based on historical averages.

I am actually surprised by how high some of the dividend yields for these banks could rise. Here are some of my favorite bank stocks with potential for great dividend yields…

Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM), two of the best-run and conservatively-managed big banks,could easily support yields of 4.6% and 4.5%.

Fifth Third Bancorp (Nasdaq: FITB) is a smaller, regional bank that has recovered nicely from a tough few years and could manage an eventual yield in excess of 8%.

U.S. Bancorp (NYSE: USB) is perhaps the best-managed bank of the lot. The bank reported impressive results for 2011, including a return on equity (ROE) in the mid-teens (17%) — the highest in the industry so far this earnings season. It has the potential for an impressive 5% dividend yield.

For those willing to gamble a bit more, Bank of America (NYSE: BAC) and Citigroup (NYSE: C) were hit pretty badly with bad loans during the credit downturn and have been slower to recover, but could pay yields of 6% or more once the dust settles and they continue to recover.  

Risks to Consider: Most investors have preferred to sit on the sidelines rather than invest in the country’s largest banks. With 2008 fresh in their minds, it’s hard to blame them, but the numbers demonstrate that the strongest and largest players have recovered from the crisis. I don’t think 2012 will see a full return to past payout levels, but it’s reasonable to see yields returning to at least 3%.

Action to Take –> Be selective among this group — and tread carefully. This can still be a volatile group of stocks, but I think the long-term payoff potential could be worth it.

This is the final piece of the puzzle. When these banks start paying higher dividends again, the share prices of these stocks could really take off. I estimate the stronger players such as Wells and JPMorgan are undervalued by at least 40% from current levels. Combine this with what should be an eventual dividend yield approaching 5%, then that’s a steal of a deal.