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Attention Dividend Investors: Danger Lies Ahead!

While reviewing the Canadian banks, the potential for investors to feel a significant amount of pain became obvious very quickly. Although long-term investors have done very well by holding many of these names over the past decade, the reality is that moving forward, there is much more potential for investors to lose money rather than realize any substantial profit.

When we consider Canada’s biggest bank by market capitalization, shares of Royal Bank of Canada (TSX:RY)(NYSE:RY) currently pay a dividend of slightly more than 3.5% and trade at a price-to-earnings ratio (P/E) of almost 14 times. As profits of the behemoth have grown over the past several years, the shares price and dividends paid have also increased along with it. The challenge now faced by investors is trying to figure out when the wave will die out, leaving them stranded. At current valuations, it is clear that what is being priced in to the share price is a significant amount of earnings growth in the coming years.

Shares of Canada’s second-largest bank are no different. Toronto-Dominion Bank (TSX:TD)(NYSE:TD) offers investors a yield of no more than 3.25%, and the price return has been more than 15% over the past year. With a current P/E of almost 14 times, the share price may seem more reasonable, but a higher Canadian dollar will hinder profit from what are now substantial U.S. operations. Although the company has done a fantastic job expanding into the United States, the landscape will present a new set of challenges.

With payout ratios (as a percentage of net profits) that are near the higher end of historical averages (approximately 45%), investors may need to pause for at least one year (maybe two) in order for earnings to catch up. As a reminder, investors have been offered very low returns on fixed-income investments over the past decade, which has resulted in many taking on additional risk in purchasing these blue-chip securities. With companies near historical highs, and close to a decade from the last recession, investors need to be cautious should earnings slow in the near future.

For those still seeking the best bank to buy, the only exception at the present time is with shares of Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM). The Canadian bank is currently trading at a discount to peers, as a major U.S.-based wealth management acquisition was recently completed, and the dust has not all been swept out from under the carpet. At a price of $115 per share, the yield remains a healthy 4.5%, as the company trades at a trailing P/E of only 10.5 times.

With the potential to discover skeletons in the closet, investors betting that there will be no more than cobwebs may want to take a crack at Canadian Imperial Bank of Commerce, as the potential for substantially higher profits and dividend increases is much more likely with this name. Barring any increase in the share price, investors will be rewarded with a higher dividend to remain patient.

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Fool contributor Ryan Goldsman has no position in any stock mentioned. 

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