Could chasing high yields mean missing out on potentially top-notch ASX dividend shares?

Don't always go for the highest-yielding shares. Here's why…

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Key points

  • Most ASX investors love a good dividend
  • But just chasing the highest yields on offer doesn't always lead to success
  • Here's how one ASX investing expert chooses a top-notch dividend share...

For many ASX dividend investors, high yields and top-notch dividend shares are one and the same. And it could be said to be fairly true, if indeed the only goal of an investor was maximising raw dividend cash flow. But if an investor was chasing overall returns rather than just pure cash, then we might start to have a problem with this thesis.

It's obvious that a high dividend yield does not equate to overall performance. One only has to look at the historical returns of some of the most famous ASX dividend shares to see this in action. Take Telstra Corporation Ltd (ASX: TLS). Telstra has long been an ASX dividend investor favourite.

Yet the Telstra share price has failed to give investors any kind of long-term capital appreciation. Indeed, its all-time high of close to $9 a share occurred in the 20th century. It has not even come close to its high watermark in the 21st thus far.

High yield ASX dividend shares aren't always winners

Or Westpac Banking Corp (ASX: WBC). As an ASX big four bank, Westpac is also a favourite of the ASX dividend investor. Yet Westpac shares are today going for the same price as the bank was back in 2006. That's a long time to wait for no capital gains.

And we won't even mention AGL Energy Limited (ASX: AGL).

So what is the best way to choose a top-notch ASX dividend share, to sort the wheat from the chaff, if not from yield? Well, let's see what an ASX expert reckons.

Rob Crookston is an equity strategist with ASX broker Wilsons. He recently penned an article on how he selects top-notch ASX dividend shares.

This is where he starts:

We think selecting a dividend strategy by its initial yield is a poor choice because the growth of the dividend over time ultimately determines the income payouts in future years…

We look for dividend-paying companies that can deliver growth year over year, continuously compounding cash flows each year. This is the template for companies we consider when thinking about income investing.

These companies typically increase the dividends they pay to shareholders due to their cash flow growth.

An example

To illustrate, Crookston compares the performances of two ASX dividend shares over the past ten years: APA Group (ASX: APA) and GPT Group (ASX: GPT). He points out that back in 2012, APA and GPT both had comparative dividend yields of around 5.3%. That would generate dividend income of $5,300 a year if an investor was to invest $100,000 into either share a decade ago

However, Crookston points out that $100,000 investment in APA would today be yielding around $11,200 in annual dividend income, or an 11.2% yield on the original capital. That's thanks largely to APA's consistent dividend increases.

In contrast, GPT hasn't been able to keep up with that kind of growth. Its shares would only be netting that same investor $6,900 in annual income today.

As Crookston explains it:

The actual market yields of APA or GPT have not diverged significantly over the last 10 years; both stocks are expected to generate a ~5-6% yield if you invested today.

However, the share price of APA has appreciated in line with the income growth and this has led to a significantly higher total return than GPT. The key here is to take a long-term approach when it comes to dividend investing.

The higher the yield, the higher the risk?

So as you can see, a company's dividend yield is just one of many factors an investor needs to consider to find really top-notch ASX dividend shares. To go one step further, the higher a company's dividened yield is, the more investors should be cautious.

The market loves a good dividend just as much as we do. And if a share has been priced with a large yield, it usually indicates that it is coming with risks attached.

So make sure you look behind that raw yield figure when trying to find your next dividend winner. Your cash flow ten years from now will thank you for it!

Motley Fool contributor Sebastian Bowen has positions in Telstra Corporation Limited. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has positions in and has recommended APA Group and Telstra Corporation Limited. The Motley Fool Australia has recommended Westpac Banking Corporation. 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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