1 Dividend Growth Stock That Will Thrive on Federal Reserve Rate Cuts

The Federal Reserve lowered its benchmark federal funds rate on Wednesday, September 18. To the surprise of some analysts, the Fed cut the rate by half a point, rather than the expected quarter point. The impact of such an action will soon ripple through the economy.

Interest rate cuts like this have a particular impact on financial institutions and lenders like banks. When the Federal Reserve lowers the federal funds rate, it tends to be reflected in the interest rates that banks charge each other and the rates they charge their customers. For example, it becomes more affordable to borrow money from a bank. At the same time, banks tend to lower the amount they pay out to depositors in high-yield savings accounts.

One of the banking sector entities that felt the effects of the increase in the federal funds rate in March 2022 was Financial ally (ALLY -1.37%). Now, the opposite is likely to happen. Here’s why Ally Financial, a dividend stock, will thrive in a falling interest rate environment.

Ally Financial: We are feeling the effects of rising interest rates

Ally Financial is a consumer bank that started out as an auto lender. It has expanded its services and now accepts deposits from individuals into its online bank—now with 3.2 million customers and $142 billion in deposits. Auto loans continue to be a large part of its business, since most of its revenue comes from lending depositors’ funds to people buying cars. Profits come from the spread between depositors’ payouts and interest on the loan portfolio.

Currently, an Ally depositor can earn 4.2% per year on the money they keep in their savings account. That yield has been steadily rising as the Federal Reserve raised its own benchmark interest rate in 2022 and 2023, so Ally has had to pay depositors more and more interest each quarter. Last quarter, Ally’s average cost of deposits was 4.21%, down from 0.76% in 2022.

While this is normal, Ally is facing pressure on its profits because the interest rate paid to depositors has risen so quickly. The bank’s loan book doesn’t turn over every quarter, but when it raises the interest rate paid to depositors, every dollar gets a higher annual profit.

Ally currently still has existing loans on its balance sheet that were made when interest rates were near zero, and therefore earn much less. That’s reflected in Ally’s net interest margin (NIM), which measures the average spread between the interest it pays to depositors and the profit it receives on its entire loan portfolio.

Ally’s NIM was 3.27% last quarter. It was 4.06% in Q2 2022. That’s a big reason why Ally’s net income has fallen in recent years. During the pandemic, Ally’s net income rose to more than $2 billion (annualized), but has since fallen to $823 million. That margin squeeze largely explains why Ally’s stock is down 40% from record highs while the broader market is soaring.

Dividend growth potential, but watch out for rising loss rates

The good news for Ally is that the headwinds from rising interest rates are likely to turn favorable starting this month.

Ally’s loan book has been maturing steadily since early 2022, with higher-yielding loans making up a larger portion of the balance sheet. The average return on assets was 7.36% in the latest quarter, compared to 5.11% in the same quarter in 2022.

With the Fed lowering the rate, expect Ally to increase its NIM over the next few quarters. When that happens, overall earnings should start to grow. When overall earnings start to grow, management could start to increase the dividend per share.

Ally’s dividend per share has increased by 275% since it was introduced in 2018, but the gains have stalled as interest rate headwinds have set in. At an annual dividend yield of 3.54%, Ally has an attractive-looking dividend with room to grow over the next few years.

One concern for the bank is the rising loss rate on auto loans. Earlier this month, an executive said that loan delinquencies rose slightly in July and August of this year. Investors should watch the data closely. If the economy enters a recession, Ally’s loan delinquencies could continue to rise.

ALLY (TTM) dividend per share data by YCharts.

Ally Financial stock looks cheap

Ally Financial looks cheap compared to other financial stocks. It has a price-to-earnings (P/E) ratio of 14.9, which is below the sector’s 16.2 P/E. Compared to regional banks (14.2), its P/E is slightly higher, but still relatively cheap, like most bank stocks right now.

Given the 6.67% earnings yield, the company has plenty of firepower to continue paying a 3.54% annual dividend yield even if earnings do not grow in the near term. Keep in mind that these are low yields due to the impact of interest rate pinching on the company’s earnings power.

If the Fed continues to lower interest rates (which analysts fully expect) and Ally’s annual net income rises to the point where it once again hits $2 billion, the stock will trade at just 5 times its current $10 billion market cap. That’s a very cheap multiple of future earnings. That’s part of why I think now is a great time to buy dividend stocks, as the Fed begins to lower interest rates.

Ally is an advertising partner of The Ascent, a Motley Fool company. Brett Schafer has no position in any stocks mentioned. The Motley Fool has no position in any stocks mentioned. The Motley Fool has a disclosure policy.