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How to decide which ASX dividend shares are right for you

With Australia’s tax system giving world-class treatment to dividend-paying ASX shares, through the use of dividend imputation and franking credits, it’s no surprise that we Australian investors love our dividends. But in my opinion, there are two kinds of dividend-paying companies: dividend-growth companies and dividend-income companies (my personal labels).

So what are the differences and which is right for you?

When I say dividend-income stock, I am talking about the more well-known companies that spring to mind when someone mentions ‘dividend’. Stocks like Commonwealth Bank of Australia (ASX: CBA) or Woolworths Group Ltd. (ASX: WOW) would come under this label.

These companies typically have above average dividend yields (typically between 4% and 8%) and high payout ratios. The thing to remember about dividend-income stocks is that these companies are usually approaching the limits of organic growth beyond population increases. This is why the payout ratios are high – the company finds more value in distributing its profits to investors than reinvesting the cash into the business. So if you invest in these companies, you will usually get a healthy income stream of (often) fully-franked dividends. This makes dividend-income stocks a great option for retirees and other income investors – but don’t expect huge capital growth or get-rich-quick opportunities from these shares.

Dividend-growth shares, on the other hand, are more about the potential growth than income. The dividend yields and payout ratios are lower – but this is a good sign as it means that the business is keeping more of the cash flow for internal reinvestment.

Take REA Group Limited (ASX: REA) for example. REA was able to achieve a return on equity (RoE) of 24% in the 2018 financial year. This means that the company was able to internally invest shareholders’ money for a 24% return on investment. If you can achieve this level of return in your own portfolio – congratulations! But this would be out of reach for most individual investors, so it would make sense to leave your money in REA shares and let the company do it for you. Although REA is currently paying a 1.53% yield, its RoE indicates that it will be able to increase this dividend fairly easily over the coming years – making it a perfect example of a dividend-growth stock.

Other great examples of dividend-growth stocks include the A2 Milk Company Ltd (ASX: A2M) and Treasury Wine Estates Ltd (ASX: TWE). So if income isn’t your primary investment objective and your investing horizon has a few years left in it, dividend-growth shares might be a better option for you.

Foolish Takeaway

Striking the right balance between growth and income is an important distinction that every investor should make within a thoughtful and goal-orientated portfolio. Depending on your individual goals and profile, either type of dividend paying share I have outlined could be right for you (or perhaps a mixture of both).

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Treasury Wine Estates Limited. The Motley Fool Australia owns shares of A2 Milk. The Motley Fool Australia has recommended REA Group Limited. 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 Scott Phillips.

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