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Look before you touch – a guide to investing for dividends

We Australians love our dividends.

And why shouldn’t we? They can provide a retiree with a regular flow of income, they can help fund a family holiday and they can give investors more capital to invest with. The franking credits that many companies attach make the returns even more exciting.

However, too many investors make the mistake of thinking that a company’s dividend yield is the be all and end all. They see a 9% or 10% dividend yield and think it’s a great investment decision, before first considering a business’ overall prospects or whether its shares are reasonably priced.

For instance, look no further than the big four banks, which have become overpriced in recent months as investors have continued to pump money into them due to their 5% or 6% dividend yields. Although each of them are amongst the strongest corporations in Australia, their shares could certainly fall in the short-to-medium terms which would reverse any distribution gains.

So what are some of the things investors should look out for?

Can the company sustain its payments?

Dividends come from a company’s profits. Before making an investment decision, it is imperative that you determine whether or not the company can maintain or improve its profitability and therefore maintain its distributions.

Metcash Limited (ASX: MTS) is a prime example. Upon first glance the stock yields 8.5%, which is a solid return by anyone’s standards. Looking a little deeper however, the company has also announced that its payout ratio will drop from 90% to 60% or lower as it lowered its earnings guidance as its Food & Grocery division continues to struggle against Woolworths Limited (ASX: WOW) and Wesfarmers Ltd’s (ASX: WES) Coles. These factors will see that yield fall substantially. Not so attractive now, is it?

Looking at the industry’s overall environment as well as the company’s competitive advantages over rivals can help determine the strength of a company.

Franking Credits

Some investors won’t touch a stock if it does not offer franking credits. In fact, many would prefer to receive a 3.5% fully franked dividend than a 5% unfranked dividend.

Franking credits simply reflect the amount of tax the company has already paid on its profits. For a 100% franked dividend, the company will have paid its 30% corporate tax obligation and distributed the remainder to shareholders. The investor is then responsible for paying any ‘extra’ tax to meet their own individual tax obligations. That is, if you’re taxed at a marginal rate of 45%, you will still need to pay tax on the 15% of the dividend that the company has not yet paid.

There is an old saying which goes “don’t let the tax tail wag the investment dog”. In other words, don’t make an investment decision based solely on the tax advantages or disadvantages included in the investment (i.e. don’t turn your back on an investment simply because it doesn’t offer franking credits).

A high dividend yield can tell more than one story

A high dividend yield cannot be taken at face value. While it can indicate a very profitable company with lots of spare cash to give back to investors, the yield can also be pushed up by a falling share price which could indicate a company that is losing its profitability (as is the case with Metcash).

What’s more, the high yield could also be the result of a special one-off dividend that has been paid, suggesting that the same amount will not be distributed in years to come.

Foolish takeaway

Telstra Corporation Ltd (ASX: TLS), M2 Group Ltd (ASX: MTU), Village Roadshow Limited (ASX: VRL) and Woolworths are all companies which you could consider buying at today’s prices. Each represent strong and growing businesses which will likely continue to grow earnings for years to come.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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