Dividends are great, as long as the company can continue paying them. When capital or cash flow runs low, dividends become a luxury that the business can no longer afford.
A strong dividend stock, then, is one that has sound business and financial fundamentals to protect that dividend from unforeseen economic shocks. A weak dividend stock, not surprisingly, is the opposite.
Today I have identified four stocks that are paying more than industry-average dividend yields, but each has characteristics that could put that dividend in jeopardy.
An inefficient bank stock is a bank stock asking for trouble
Up first we have Old National Bancorp (NASDAQ:ONB), a $10.4 billion regional bank headquartered in Evansville, Ind. Currently, Old National yields a dividend yield of 3.4%, per data from S&P Capital IQ.
The trouble for Old National is its efficiency, measured by the bank's efficiency ratio. The efficiency ratio is calculated by the bank's non-interest expenses into its net revenue. The lower the results ratio, the better. Old National currently sports a 75.6% efficiency ratio as of June 30. For context, the FDIC reports that at the same quarter end, the average efficiency ratio for banks with greater than $10 billion in total assets is 59.5%.
For Old National, this means that for every dollar of revenue, the bank has at least $0.15 less than the average bank to pay taxes, buy back shares, or pay its dividend. In other words, money is tight.
IberiaBank Corp. (NASDAQ:IBKC) is in a similar situation. The bank's dividend currently yields 2.1% and has an even worse efficiency ratio than Old National does.
IberiaBank reported an efficiency ratio of 79% for the second quarter. On average, IberiaBank has $0.20 less per dollar of revenue to potentially use on a dividend.
IberiaBank does have one advantage over Old National: It has just one-third the level of problem assets on its balance sheet as Old National. Problem assets are loans that are severely past due plus foreclosures. WIthout those problem assets bogging down the bank, Iberia has a better shot at improving its operations.
Excess leverage puts everything at more risk, including the dividend
Banks are, by their very nature, highly leveraged. A typical bank balance sheet will have about 10% equity and 90% debt. That means that if a typical bank sees the value of its assets drop by only 10%, then all of the company's equity is wiped out.
Don't forget, that scenario is for the typical bank. For a bank with even more leverage, the risk is that much greater.
Enter the Toronto-Dominion Bank (NYSE:TD). At first glance this bank looks fantastic. Its return on equity was 15.5% in the second quarter, its dividend yields 3.4%, and its efficiency ratio is an impressive 52%. However, to accomplish those great returns, the bank employs an assets-to-equity ratio of 16.8. That's a lot of leverage and a lot of risk.
The Bank of Hawaii (NYSE:BOH) is a similar case. The bank's return on equity is better than TD Bank's at 16%, and its efficiency ratio is in line with industry averages at 58%. The bank's dividend yield is currently 3.1%.
But once again, the bank uses a ton of leverage to boost those returns, though not as severely as TD Bank. The Bank of Hawaii's assets-to-equity ratio is still over 14, though.
Both of these banks otherwise have very attractive looking financials, and it seems that up until this point, using that leverage is working out fine. The problem, of course, doesn't happen when business is booming; it's when the economy hits a snag that today's success become tomorrow's losses.
The key is to know the risks
To be clear, I am not saying that any of these four banks will imminently cut their dividends. My objective here today is to merely point out a few red flags that every investor should consider.
Dividends can be paid only when a company has adequate profitability and capital. These banks have weaknesses that could create problems in those two exact categories -- either by having an inefficient operation that hinders profitability or significant leverage that could put capital at risk.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of Bank of Hawaii. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.