When hunting for dividend stocks, it's wise to be sceptical if a yield looks too good to be true. Often, an overly generous yield is a signal that the market is expecting a dividend cut.
In order to determine whether a dividend is sustainable it pays to examine a company's revenue and earnings trends, and also look at metrics such as the dividend coverage ratio and free cash flow yield.
While the FTSE 100 is full of high-yielding stocks, there's no doubt that caution is warranted in this cost-cutting environment. With that in mind, here are three FTSE 100 stocks with dangerously high yields.
HSBC's(LSE: HSBA) yield currently stands at a huge 8.14%. This is far above both the average FTSE 100 yield of 4.54% and its banking peers, and this super high yield should be ringing alarm bells straight away.
The banking giant posted a revenue drop of 4% to $13.9bn last week, and while management stated that it remains committed to the dividend, going by the sustained sell-off in the shares over the last year, it appears the market is sceptical.
Dividend coverage (the ratio of net income to dividends paid out) for HSBC stands at 1.29. The general rule of thumb is that a ratio under 1.5 indicates that the dividend is at risk, while a ratio of 2.0 is healthier.
With pressure on the bank to reach its regulatory capital requirements, it's no wonder there are questions as to whether HSBC's dividend is sustainable.
Oil price issues
It's no surprise that Royal Dutch Shell's(LSE: RDSB) dividend yield has increased significantly, as the falling oil price has been a disaster for oil-related companies. In the last two years, Shell's share price has fallen from £26 to around £17, and this has resulted in a high yield of 7.46%.
Shell is a company with a strong dividend history having weathered oil price fluctuations for seven decades without cutting its payouts to shareholders. And management has made it clear that even in the current low oil price environment, dividends are a top priority. But with a dividend coverage ratio of just 0.16 is the yield really sustainable?
Shell paid out dividends of £1.88 last year on the back of basic earnings per share from continuing operations of £1.39 per share. Clearly this isn't sustainable, and with consensus earnings estimates of £1.14 per share for FY16, the situation is only going to get worse.
For Shell to maintain it's dividend, the price of oil needs to rise quickly.
Education specialist Pearson(LSE: PSON) is another company that's struggling under challenging conditions.
While its yield of 6.44% isn't as high as those of HSBC or Shell, a closer examination reveals that the dividend may still be at risk of a cut.
In both FY14 and FY15, dividends paid out were greater than earnings from continuing operations. In fact, last year's dividend payout ratio was a whopping 158%, clearly an unsustainable situation.
And with revenues still falling and a mounting debt pile, I certainly wouldn't bank on this dividend going forward.
Edward Sheldon owns share in Royal Dutch Shell B. The Motley Fool UK has recommended HSBC Holdings and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.