Last week, I promised to conduct a “stock war” to identify the most compelling Canadian bank stock to own headed into 2012. And it’s time to deliver.

To do so, though, I need to apply some initial screens to whittle the list of six Canadian bank stocks down to the two top contenders…

First, let’s exclude any banks that don’t possess double-digit capital appreciation potential. (We can calculate this by comparing each bank’s current price-to-earnings (P/E) ratio to its five-year average P/E ratio.) Doing so immediately puts Canadian Imperial Bank of Commerce (NYSE: CM) out of contention.

[ad#Google Adsense 336×280-IA]Next, let’s eliminate any banks with significant exposure to the United States and/or Europe. The reason? Because both regions represent the highest risk when it comes to financial stocks. Since we’re after a safe income investment, we want to avoid such risks. That allows us to cross Toronto-Dominion Bank (NYSE: TD) and Bank of Montreal (NYSE: BMO) off the list.

Lastly, let’s insist on banks that generate 50% or more of their profits from plain vanilla banking in Canada – accepting deposits and making loans. Why? Because boring businesses make money. Plus, they’re safer. As I told you before, “The fewer moving parts, the fewer things that can go wrong, thus sapping cash intended for dividend payments.” Doing so puts Bank of Nova Scotia (NYSE: BNS) on the “reject” list.

A Battle of David Versus Goliath

In the end, we’re left with two banks – Royal Bank of Canada (NYSE: RY) andNational Bank of Canada (Toronto: NA.TO).

Ironically, the former is Canada’s largest bank, while the latter is the smallest of the “Big Six.” So who wins this battle of David versus Goliath? Let’s take a look at five key fundamental factors to make a determination…

~ Economic Moat: Warren Buffett coined this term to define the competitive advantages a company possesses that act as barriers to entry for competitors. Thanks to strict government regulations, the “Big Six” Canadian banks all possess solid economic moats.

That being said, National Bank of Canada’s business is primarily concentrated in one province (Quebec), whereas Royal Bank of Canada’s business is well diversified across the entire country.

Advantage: Royal Bank of Canada

~ Profitability: One of the most important profitability metrics to evaluate is return-on-equity (ROE). Both banks pass muster.

Over the last 12 months, Royal Bank of Canada’s ROE checks in at 15.9%, compared to National Bank of Canada’s ROE of 15.8%. Over the last 10 years, both banks average ROE stands at approximately 17%. Talk about neck and neck.

Advantage: Draw

~ Financial Strength: The quickest way to determine a bank’s financial strength is to do what regulators do, check its Tier 1 Capital ratio. This measures the ratio of a bank’s core equity capital to its total risk-weighted assets. In laymen’s terms, it helps determine whether a bank is well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized.

As a frame of reference, banks with Tier 1 Capital ratios of 6% or less aren’t permitted to pay dividends. Thankfully, Royal Bank of Canada and National Bank of Canada are nowhere close to that level. Instead, they sport solid Tier 1 Capital ratios of 13.2% and 13.9%, respectively. In other words, both are well capitalized.

Advantage: Draw

~ Valuation: Capital appreciation shouldn’t be our primary concern. Income should. But that doesn’t mean we should ignore the potential. The more the better, right?

In this case, Royal Bank of Canada possesses more upside potential. It’s currently trading 37.6% below its five-year average P/E ratio is 15.0. Meanwhile, National Bank of Canada is trading at a 21.4% discount to its five-year average P/E ratio of 11.9.

So if both stocks trade back to their historical averages, Royal Bank of Canada will reward shareholders more.

Advantage: Royal Bank of Canada, based on the discount to its five-year average P/E ratio.

~ Yield: At current prices, National Bank of Canada currently yields 4% and Royal Bank of Canada yields 4.4%. That’s a small difference, but over time small differences can add up.

Advantage: Royal Bank of Canada

And the Winner Is…

Bottom line: Goliath wins! Thanks to its cheaper valuation, higher yield and wider economic moat, Royal Bank of Canada edges out National Bank of Canada to rank as the most compelling income investment headed into 2012.

Ahead of the tape,

Louis Basenese

[ad#jack p.s.]

Source: Wall Street Daily