Canada’s banking sector is a very popular hunting ground for dividend investors. The Big Six banks have long histories of paying and growing dividends, strong balance sheets, and dominant positions in a protected oligopoly. But that does not mean every Canadian bank is a great investment.
Once you move outside the Big Six and start looking at smaller names, the picture changes quickly. In theory, these should be scrappy challengers trying to disrupt the incumbents. In reality, Canada’s tightly controlled banking market often leaves it stuck in permanent second place.
A good example is Laurentian Bank (TSX: LB). If you screened Canadian banks by dividend yield, this one might catch your eye. Based on its most recent quarterly payout, the stock currently offers a forward dividend yield of about 4.66%.
But that headline number hides some serious financial problems, and once you dig into the fundamentals, the story only gets worse. Here’s why I would avoid Laurentian Bank as a dividend trap.
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Why Laurentian Bank has poor fundamentals
Banks are not evaluated quite the same way as most companies. A normal business sells products or services. Banks make money primarily by taking deposits, lending that money out at higher interest rates, and capturing the spread between those two rates. They also earn income from fees, trading, and other financial services.
Because of this structure, traditional valuation metrics do not always tell the full story. Two metrics I pay close attention to when evaluating banks are price-to-book value and return on equity.
Book value matters for banks because their assets are largely financial instruments such as loans and securities. In other sectors, book value is less meaningful, but for banks, it still provides insight into how the market values their balance sheet.
Healthy banks typically trade somewhere between one and two times book value. Below one times book can sometimes signal a bargain, but it can also signal deep problems.
Laurentian Bank currently trades at about 0.67 times book value. At first glance, that may look cheap. You are buying the bank for less than the value of its assets.
But banks do not trade below book value without a reason. Investors are effectively saying the assets on that balance sheet are not generating attractive returns.
That brings us to the next metric. Return on assets for banks is usually very low. That is not unusual because banks operate with enormous balance sheets and heavy leverage.
Return on equity is the real test of efficiency. A strong bank should produce a return on equity above 10%. Many of the large Canadian banks operate comfortably in the low to mid-teens.
Laurentian Bank’s return on equity is just 2.84%. That is extremely weak for a financial institution and helps explain why the stock trades at such a steep discount to book value.
The future for Laurentian Bank
I am bearish on Laurentian Bank. The company has spent years exploring strategic alternatives, including attempts to find a buyer. Those efforts have repeatedly fallen apart after potential acquirers took a closer look at the business.
That does not inspire confidence. Yes, the stock has rallied recently. Over the past 12 months, Laurentian shares have climbed about 52.6%. But a short-term rally does not fix long-term structural problems.
The balance sheet also raises concerns. As of the most recent quarter, the bank held about $9.2 billion in cash against roughly $17.77 billion in debt. Over the trailing 12 months, operating cash flow was negative $847.5 million.
For me, this is not a stock worth owning just for the dividend. If you want exposure to Canadian bank dividends, a better approach may be to use an exchange-traded fund (ETF) that holds all six major banks.
Some ETFs even enhance the yield by writing covered calls or applying modest leverage of around 1.25 times. That way, you still benefit from the sector’s income potential without betting on one struggling player.
