Australian investors are in love with dividend paying shares!

The problem is, income-paying shares are only good if earnings are sustainable. Recent reports indicate that some of Australia’s largest companies are getting set to slash dividends. Companies like BHP Billiton Limited (ASX: BHP), Rio Tinto Limited (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG), to name a few.

Now, is a good time to step back and review your dividend investing strategy.

What is dividend yield?

The dividend yield simply means how much a company pays out in dividends each year relative to its share price. So, if the company’s share price is $10, and its dividend is $1, then the dividend yield is 10%. If the share price drops to $5 and the dividend remains at $1, then the yield would be 20%.

Tips to avoid the dividend yield trap!

1.Don’t chase yield blindly

Dividends are good for income, but this doesn’t mean that the highest yielding ones are better. When a company’s dividend yield is increasing, it’s important to recognise whether this is due to a falling share price.

2.Beware companies with deteriorating fundamentals still paying dividends

Beware the company that has deteriorating fundamentals but attempts to maintain its dividend policy, usually financing the payout with debt or even worse, new equity capital.

3.Beware the large “one-off” dividend

Companies will often come into excess cash through one-off events such as the selling assets or parts of their business. It is naive to think that this is somehow an indication of the company’s future performance. Check their dividend history!

4.Special dividends

As with “one-off” dividends, companies come into extra cash thanks to a “one-off event” or an exceptional year. Once again, take a close look at the company’s dividend history and ask yourself if the same event is likely to occur into the future.

5.A high payout ratio

It’s not uncommon for a company’s earnings to fall and its payout ratio to climb above 100% or more. Because it’s paying out more than its earning it’s generally unsustainable. This situation typically ends in dividend cuts.

6.The cash flow statement

Always, always, always look at the company’s cash flow statement to see whether it has sufficient funds to pay its dividends, or if dividends are being paid by increased debt or new equity raisings.

7.Strong performing shares

Look for the highest yielding shares that have performed well over the past six to twelve months. This indicates that the company has positive price momentum.

Following is a list of 10 shares that have solid yields and strong share price gains over the past six months (compared to the index). I’ve excluded small caps, and shares with negative yields or payout ratios greater than 100%.

 Company Price Performance (6 Mos)* Div Yield*
Trade Me Group Ltd (ASX: TME) $3.69 26.8% 4.2%
Spark New Zealand Ltd (ASX: SPK) $3.15 22.1% 6.3%
AIR N.Z. FPO NZ (ASX: AIZ) $2.74 15.1% 6.2%
Navitas Limited (ASX: NVT) $4.68 13.9% 4.2%
Flight Centre Travel Group Ltd (ASX: FLT) $38.50 13.4% 4.0%
Village Roadshow Ltd (ASX: VRL) $6.91 13.1% 4.1%
JB Hi-Fi Limited (ASX: JBH) $22.12 12.8% 4.2%
Super Retail Group Ltd (ASX: SUL) $10.03 10.3% 4.1%
SKYCITY Entertainment Group Limited-Ord (ASX: SKC) $4.18 9.4% 4.5%
Pact Group Holdings Ltd (ASX: PGH) $4.90 9.1% 4.0%

(Source: Commsec)

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Motley Fool contributor John Hopkins has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.