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Analysts expect that the Big Six can deliver stronger profits as the economic recovery takes hold and businesses and consumers tap banks for more loans – suggesting that investors can be rewarded for sticking with stocks that are no longer cheap.Chris Wattie/Reuters

The share prices of Canada’s Big Six banks reached record highs after the banks finished reporting their quarterly financial results last week, raising the question of how much further this rally can go as valuations rise.

Bank stocks looked exceptionally cheap last year, as investors took a cautious approach during much of the lockdown. Weak economic activity and high unemployment weighed on the sector, and the banks had to freeze their dividends and set aside huge reserves to cover the prospect of defaulting loans.

In March, 2020, during one of the bleakest periods of the pandemic, bank stocks on average traded at just 7.4 times estimated earnings and one times book value per share, according to a National Bank of Canada report from last year. These valuations were well below historical averages.

What’s more, dividend yields soared to an average of 6.4 per cent as stock prices tanked.

Today, the sector looks entirely different, as economic activity rebounds and the threat of loan defaults has begun to fade.

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Valuations have recovered to their historical averages, or slightly above them according to some analysts’ measures. The group’s price-to-earnings ratio is now at 11, versus a five-year average of 10.8, according to CIBC World Markets’ earnings estimates for 2022.

The price-to-book ratio is 1.8, or a bit higher than the five-year average of 1.7.

As for those big dividend yields, they are down to an average of 3.6 per cent, after share prices soared more than 80 per cent from their pandemic lows.

But analysts expect that the Big Six can deliver stronger profits as the economic recovery takes hold and businesses and consumers tap banks for more loans – suggesting that investors can be rewarded for sticking with stocks that are no longer cheap.

“Multiples are not stretched and there are good arguments why banks should trade at higher-than-average multiples today,” Paul Holden, an analyst at CIBC World Markets, said in a note.

Appetite for loans hasn’t kicked into high gear yet. Loan growth was less than 1 per cent in the fiscal second quarter.

However, there are signs that loan growth is picking up. Credit-card balances shrank by just 0.7 per cent in second quarter, which is a big change from the 6.5-per-cent decline in balances in the fiscal first quarter. As well, unsecured personal loan balances increased by 1.6 per cent, after declining in the previous quarter.

Meny Grauman, an analyst at Bank of Nova Scotia , pointed out that much of the discussion around bank operations touches on “tailwinds,” underpinning expectations that the sector is poised for an economic boom that could last years.

“This is now the consensus position, but despite that broad-based bullishness forward [profit] estimates continue to be conservative, in our view, as both the magnitude and timing of the recovery remain highly uncertain,” Mr. Grauman said in a note.

If profits continue to exceed expectations – as they did last quarter – today’s stock valuations might even turn out to be relatively low, as the economic recovery takes hold.

Based on earnings estimates from National Bank analyst Gabriel Dechaine, the banks’ price-to-earnings ratio is 11.2 – close to the CIBC estimate – which the analyst noted is slightly on the low side for the first year of an economic recovery.

As for today’s relatively meagre dividend yields, they aren’t reflecting the prospect of higher distributions.

The banking regulator put a halt to distribution increases last year so that the banks could build their reserves to handle loan defaults. The banks are now sitting on a combined $37-billion in excess capital, according to Mr. Dechaine.

Some of this capital will likely be paid out in higher dividends when provisions for loan defaults are “released,” or no longer required, suggesting that the average yield could jump when the regulator gives the go-ahead.

“We believe that improving growth dynamics coupled with capital distribution catalysts and prospects of more material provision releases in the second half will add further momentum to bank stocks as we enter a seasonally strong performance period,” Mr. Dechaine said in a note.

Full disclosure: The author owns units of the BMO Equal Weight Banks Index ETF.

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