Last week, analysts at Barclays downgraded the stock of Canadian-based Toronto-Dominion Bank (NYSE:TD), commonly known as TD Bank. The stock fell nearly 3% on the news, before recovering slightly to close the week at $39.83.
Many investors turn to TD Bank as an investment over other institutions because of the bank's impressive 4.1% dividend yield. In light of the downgrade, let's review the reasons for the downgrade to assess how it could affect the dividend.
From equal weight to underweight
The downgrade moved Barclays' recommendation from a neutral equal weight to a negative underweight. Barclays also moved the price target for the bank down from $57 to $53.
Barclays anticipates lower growth ahead for all Canadian banks and points to the Bank of Canada's recent interest rate reduction as evidence. The move to lower rates is intended to boost spending and implies lower demand in the Canadian economy. TD Bank reported in October that 66% of its net income is attributable to Canadian operations.
With the broader weakness in the economy, the analysts expect that earnings-per-share growth could slow at TD Bank, a change that would put downward pressure on the bank's stock.
A margin of safety
A decline in the stock price wouldn't necessarily drive a reduction in the dividend, though. That would require changes to the fundamental performance of the bank.
The key to maintaining the dividend is building a margin of safety in both capital levels and earnings. Dividends are paid with earnings, and they're possible only when the bank doesn't need to keep the profits on the balance sheet to increase capital.
On a trailing-12-month basis, TD pays out just over 40% of its profits as dividends. That ratio has oscillated over the past 10 years in a range between 25% and 60%, a level that's sustainable with current profitability and provides a comfortable margin of safety.
If the analyst at Barclays is correct about slowing demand in the Canadian economy, I believe that TD Bank has a sufficient margin of safety that will protect the dividend from a decline in profits.
Flirting with danger
The second consideration is capital. Banks are required to maintain capital levels sufficient to protect the bank in the event of a severe recession. Those levels are specific to each bank, dependent on its size and systemic importance.
TD reported a common equity tier one capital ratio of 9.4% for the 2014 fiscal year, which is considered well capitalized by all regulatory bodies.
That said, TD's capital is markedly lower than some other large North American institutions. Bank of America (NYSE:BAC) reported a common equity tier 1 ratio of 12.4% as of Dec. 31. Wells Fargo (NYSE:WFC) reported its ratio at 11.4%.
In terms of margin of safety, TD Bank is flirting with danger by maintaining a relatively lower capital level. If the economy were to turn significantly for the worse, the bank could find itself forced to cut the dividend by regulators to boost capital.
No danger on the horizon... yet
As of today, there is no imminent threat to TD Bank's dividend. The issues that Barclays brought up in supporting the downgrade are real, but they aren't so severe as to warrant an impending dividend cut.
However, it's my opinion that TD Bank is exposing itself and its shareholders to undue risk by keeping its capital ratios lower than other large, North American banks. The financial crisis painfully illustrated the dangers of inadequate capital in the banking system. It can destabilize a bank at its very core, and that's a problem with considerably more of an impact than a temporary dividend cut.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.