Motley Fool Australia

Your Definitive Guide to Dividend Investing

Using dividend-paying ASX shares as the backbone of a diversified portfolio is a wonderful thing. Yield and passive income are commodities that have become increasingly scarce in our modern, low-interest rate world.

However, those new to investing might have some questions about dividends. But knowing what a dividend is and how dividends work is only half the battle. Knowing how to make the best use of dividends can set you on the path to true financial freedom. 

Here is a dividend investing guide that will provide you with a basic understanding of what dividends are and help you create your own dividend portfolio strategy.

Guide Last Updated: 8 September 2020

What is a dividend?

An investment in an ASX share is, at its core, a claim on the ownership of a company, a business, and therefore on the long-term stream of cash flow and profits generated by said company.

There are different ways to benefit from these cash flows as an investor, with the two main sources being an increase in stock prices due to growth in the business, referred to as capital appreciation, and cash distributions funded by the ongoing cash flows the business generates. 

Dividends are a form of cash distribution and represent a tangible return that you can then use for other purposes.

A dividend-paying company is, essentially, writing a cheque to its shareholders out of the profits it generates. For investors who use a broker, which is most investors, that cheque will simply be a deposit that shows up in your brokerage or bank account. Dividends are generally paid to shareholders at regular intervals, with semi-annual payments (every 6 months) the most commonly chosen interval in Australia. However, dividends can also be paid monthly, semiannually, annually, and even on a one-off basis, in the case of “special” dividends.

To help with the processing of dividends, there are a few key dates to watch. Most notable is the ex-dividend date, which is the first trading day on which a future dividend payment isn’t included in a share’s price. After the ex-dividend date, a share trades as if it has already paid the dividend. If you buy the stock before that date, you get the dividend. If you buy the share after the ex-dividend date, you don’t receive the dividend.

This all may sound a little complicated right now, but after spending a little time understanding dividends, you’ll see that they’re pretty easy to get your head around. Despite their simplicity, however, they can have a huge impact on your financial life. 

A real-world example will probably help here. Commonwealth Bank of Australia (ASX: CBA) first floated on the ASX back in 1991 for $5.40 per share and has paid a semi-annual dividend every March and September since. Even if we take CBA’s current 52-week low of $53.44, investors would still be looking at an 890% return since 1991 on capital appreciation alone.

But investors who took those 2 dividend payments every year and bought more Commonwealth Bank shares (known as reinvesting) would be looking at a return of over 7,200% instead. This is because they were buying shares all along, increasing their investment with each dividend received. It’s compound interest and dividend investing at its finest.

Are dividends a good thing?

glass jar containing coins labelled dividends

For some investors, dividends are great…for others, dividends are a nuisance. In the end, whether you think dividends are good or bad will really depend on your investment approach and temperament. For example, some investors use their dividends to fully fund their retirement outright or at least supplement the Aged Pension with an additional stream of passive income. 

These investors love dividends. As do many others. Dividends can help boost portfolio returns in good times and bad. Cash payments aren’t subject to the whims of the markets like a share price is – meaning that these payments can cushion the returns of a portfolio during a share market correction or crash. Some investors just enjoy seeing their capital produce yield in the form of cold, hard cash – cash that doesn’t discriminate and doesn’t need to be worked for.

Other investors, those who wish to avoid tax or who are still building a nest egg, might prefer to see a company reinvest all of its cash into the business to spur higher levels of growth. Investors like that might deem dividends a waste of good money.

Why? Because each dollar paid out as a dividend is a lost opportunity for the company in a way. If a company can get a return on invested capital of 15%, each dollar paid out one year would be worth a tax-free $1.15 within the company by the following year if it had been saved and reinvested (and $1.32 in the one after that). As a shareholder, you still have a right to these earnings, but they are being reinvested (probably at a higher rate of return than you could achieve) rather than returned to you.

Some investors might also prefer to see cash used to buy back company shares instead of pay dividends. Buying back shares is another way in which companies can return cash to shareholders without actually distributing the (taxable) money to shareholders. 

The ownership interest in a company is spread across the total number of shares a company issues. By reducing the number of shares outstanding via a buyback, the company gets to spread earnings over a smaller share base. So every share is awarded a larger piece of the company’s earnings, which, in turn, increases earnings-per-share growth. It also results in each investor owning a larger share of the company over time with no other intervention. Since earnings are a key metric by which company success is graded by investors, higher earnings generally lead to higher share prices.

Some companies like to use share buybacks because they don’t actually have to complete buybacks even if they announce them. This provides more flexibility in case the business environment changes or a company’s share price fluctuates in value. Investors tend to react poorly if dividend payments are reduced even if a company is facing hard times.

Some key dividend metrics

Now that you’ve got an understanding of how dividends work, you’ll want to understand some of the key metrics you’ll see when researching dividend shares. 

Dividend yield

The most prominent is the dividend yield. This is generated by taking the most recent dividend payment and multiplying it by the dividend frequency (how many times a year the dividend is paid) and then dividing by the current stock price.

The higher the yield the better for most income investors, but only up to a point. Abnormally high yields can indicate heightened levels of risk. A good reference point for investors is to compare a stock’s yield to that of the S&P/ASX 200 Index (ASX: XJO) to get a sense of whether it is high or low, since market conditions can change over time. 

Yields should also be compared to those of direct peers to get a sense of how high or low a yield is, since some industries historically tend to offer higher yields than others, for example, the banking, consumer staples or resources industries. 

Note that most financial data services will provide a trailing dividend yield, which takes historical dividends that were paid (usually over the last 12 months) instead of looking at the current or projected dividends and multiplying by the frequency.

Payout ratio

Another metric that investors focus on is the payout ratio. This can be derived by taking the dividend and dividing by the company’s earnings per share. Although dividends don’t get paid out of earnings, this gives an idea of how easily a company can afford its dividend. The lower the payout ratio the better, with ratios over 100% worthy of additional research (noting that some industries, such as real estate investment trusts, often have payout ratios over 100% because of heavy depreciation expenses). This figure can be calculated over different time periods, but it is usually looked at semi-annually, over the trailing 12 months, or annually.

Yield on purchase price

Some investors will also look at yield on purchase price. You calculate yield on purchase price by taking the current dividend per share and dividing it by your average cost per share. This is a number that is, obviously, specific to each individual investor. It is most appropriate for investors who have owned a dividend-paying share for a very long time and for those who have used dollar-cost averaging to create their position. 

For example, if you had purchased Commonwealth Bank when it first floated in 1991 for $5.40, the dividend was $0.40 per share per year, providing investors with a rough 7.4% starting dividend yield (not bad). By 2019, the dividend had grown to $4.31 per share. That’s a yield on cost or the purchase price of 79.81% every year for those lucky investors.

How are dividends decided?

At the most basic level, the chief executive officer (CEO) of a company makes a recommendation to the board of directors on what he or she believes is an appropriate dividend policy. 

Often there is no specific public policy to go off of, usually just the dividend history, which most dividend-paying shares aim to increase over time. But some companies do make specific dividend goals, perhaps targeting a percentage of earnings or cash flow. Coles Group Ltd (ASX: COL), for example, targets a payout ratio of 80–90% of its earnings. This can help give investors certainty over time over the income they can expect to receive from their shares.

It’s important to note that the CEO isn’t the one making the final call here; the board of directors is. This collection of individuals comprises the elected representatives of the shareholders. They are effectively the boss of the CEO and have the final say on key issues, including how a company’s profits should be used. Dividends are a big piece of that story. 

So the board takes the CEO’s advice, discusses it, and votes on what it believes the dividend should be. The types of issues a board might look at include but are not limited to, the company’s profitability, available cash, leverage, and future capital needs.

Some companies may also have to answer to a higher power in the payment of dividends too. These companies (such as those in the banking sector) have their financial positions audited by the government to make sure they are able to support the broader Australian economy in tough times. We recently saw the Australian Prudential Regulatory Authority (APRA) issue guidance to the large Australian banks like Westpac Banking Corp (ASX: WBC) not to pay substantial dividends in 2020.

As the level of economic uncertainty has somewhat abated, APRA partially downgraded this guidance at the end of July 2020. The authority's current guidance is that banks and insurers should exercise caution in planning their dividends for the remainder of 2020. Most businesses won’t be subject to this kind of external influence, but still, some are. 

Some key dividend dates

2019 calendar and a pencil

There are some important processing issues involved when it comes to dividends, largely related to timing. The first is the declaration date, which is when a company announces its dividend plans to the market through an ASX release. In this release, in addition to the actual dividend amount, it will report the record date, the ex-date, and the payment date, as well as the level of franking. To understand this process, it may help to look at a real-life example.

On 18 August 2020, Coles Group put out a news release informing investors and the public about its intention to pay a final dividend for the second half of FY2020 (January to June 2020) of 27.5 cents per share. 

That ASX release was the official declaration of the dividend. In addition to the amount per share, the company also reported that the dividend would be paid on 29 September to shareholders on record as of 28 August. 

The payment date is the day on which shareholders will receive the dividend. 

The record date is effectively the day the company makes the list of all of its shareholders for the purposes of allocating dividend payments. 

The ex-dividend date is usually one day before the record date (in this case 27 August). That means if you wanted to receive this dividend for any new COL shares you planned on buying, 26 August was the last date any new shares would be eligible for this dividend (you might hear some people say ‘before it goes ex-dividend’) as the record will be taken the following day.

Ex-dividend date

But the most important date is the ex-dividend date. Purchase the shares prior to that date and you will be eligible for the dividend; buy on or after the ex-dividend date and the previous owner will get the dividend. In effect, the actual ex-dividend date is the specific date on which the stock will trade without the dividend included in the price.

For most investors, particularly those with a long-term view, these dates will not be too big an issue. However, if you are looking to buy a stock, you might want to double-check the dates just in case. You’d rather get a dividend than miss it by a day or two because you procrastinated.

Dividend harvesting

Some investors, meanwhile, try to ‘harvest’ dividends by investing around these dates. Dividend harvesting (also called dividend capturing) is a strategy in which investors only hold shares long enough to receive the payment before selling and moving on to another share. In this way, the investor can invest in many dividend stocks with the same money and “capture” more dividends. Although this sounds like a great idea, it is complicated and time consuming.

There’s another technicality that complicates the dividend harvesting approach: Dividends are technically a return of retained earnings (a balance sheet item) – in other words, money leaving the company permanently and going into shareholders pockets. 

As such, the share price logically should fall by the amount of the dividend once it hits the ex-dividend date – theoretically it’s a zero-sum game. 

There’s also the risk that the stock price could be moved by company news or events in the broader market during the holding period. So you will generate income from the dividend you collect, but you could end up with an offsetting capital loss when you sell the shares. It’s very possible that the net benefit will be less than you might hope, and thus, we Fools think most investors shouldn’t get involved with dividend harvesting.

Dividends, franking and tax

No discussion of dividends would be complete without mentioning franking credits and taxes.

Dividend payments are normally treated as personal income by the Australian Taxation Office (ATO). You will have to declare any dividends you receive during the financial year as income when you do your annual tax return (just like you would with other investment income like rent or interest). Even if you decide to re-invest those dividends into more shares of the payer (more on that later), the ATO will still treat this re-investment as if you’d received the payments in cash. 

Taxes are a complex topic, and you should consult an accountant or tax professional for an in-depth discussion here. But rest assured that you need to let the ATO know about your dividends, or they will be sure to hunt you down and extract their pound of flesh.

But many Australian investors are attracted to dividend-paying shares for another reason: franking credits.

What are franking credits?

Here in Australia, we have a rather unique system of treating the taxes one has to pay on dividends. It’s known as franking. 

See, when a company pays a dividend, that dividend comes out of a company’s profits. Those profits have already been taxed by the government on the corporate level (usually at 30 cents in the dollar).

In many other countries, investors then have to pay income tax on the dividend payments, meaning the dividend has essentially been taxed twice. 

But here in Australia, the government has adopted the franking system to make sure the dividend payments are only taxed once. So if a company’s dividend comes from profits that have been taxed in Australia, any dividend that will subsequently be paid from these profits will come with an acknowledgement of this tax already paid. This acknowledgement is known as a franking credit, and it enables you to take the equivalent amount away from your taxable income as a deduction. If you have no taxable income, then you are eligible to receive these franking credits as a cash refund.

As a result, an ASX company’s dividend can be worth more to an investor than it might initially appear. If Coles pays a 60 cent per year dividend and its share price is $16, then its raw dividend yield is worth 3.75% a year to an investor who buys Coles shares at $16. But if you include the value of the full franking credits that Coles’ dividends come with, the ‘grossed-up’ yield with these included is now 5.36% instead. 

Sometimes a company will only pay some or no taxes in Australia and some offshore (such as a company with overseas interests). These companies sometimes pay ‘partially franked’ dividends or ‘unfranked dividends’, meaning they come with an acknowledgement of none or some tax being paid, but not at the full 30% rate. 

Thus, the franking credit will be less (eg. 70% franked dividend) or non-existent (an unfranked dividend). 

Other companies, notably real estate investment trusts (REITs), are structured as pass-through entities because they pass much of their income to investors in exchange for avoiding corporate-level taxation. Most if not all of the dividends they pay are treated as regular dividend income with no franking, as tax is only paid once.

Are all dividends created equal?

Symbol of scales is made of stones on the boulder

Yes and no. It really depends on the ASX shares in question.

Most ASX shares pay 2 dividends a year. The first will normally be referred to as the ‘interim dividend’ and the other as the ‘final dividend’. Some companies pay a smaller interim dividend and a larger final dividend. Others will pay an equal amount. 

If a company wants to pay a dividend outside these parameters, it will normally be classed as a ‘special dividend’. Special dividends can reflect many things. They can be a once-off payment, or an ongoing arrangement. For example, BHP Group Ltd (ASX: BHP) paid a one-off special dividend in January 2019 as a result of the sale of some assets. As this was a one-off transaction, the dividend was also of a ‘once-off’ nature.

Other special dividends can reflect the circumstances of the company’s earnings. Telstra Corporation Ltd (ASX: TLS) has for years paid a ‘special dividend’ on top of its regular interim and final dividends to reflect the ongoing compensation the company receives as part of the NBN rollout.

Other ASX investment vehicles such as exchange-traded funds (ETFs) or listed investment companies (LICs) that hold ASX shares within them can also pay dividends (these are sometimes called distributions to reflect this indirect nature). 

For example, an ASX 200 index fund such as the iShares Core S&P/ASX 200 ETF (ASX: IOZ) holds all 200 shares of the ASX 200 – most of which pay dividends. The dividends the fund receives will be passed on to the owners of the fund as distributions.

Not all dividends are paid in cash

To complicate things even more, dividends aren’t always paid in cash. A company can theoretically award its shareholders with company shares rather than cash payments with a dividend – although this isn’t often seen on the ASX.

A more common scenario occurs if a company decides to ‘spin-off’ part of its business into a new company. The spin-off is sometimes executed via a stock dividend in the new company. This happens when a company gives shareholders freshly created shares in one of its operating divisions so that it can break the division off as its own public company.

A good example was the spin-off of South32 Ltd (ASX: S32) from its former parent company BHP. In 2015, BHP decided to split some of its mining operations into a separate company that became South32. At the time of the split, existing BHP shareholders were allocated one S32 share for each BHP share they owned. 

These kinds of ‘dividends’ are usually taxed differently or not at all, as they represent a restructuring of capital rather than a distribution of wealth.

What is a DRIP?

An acronym you’ll frequently hear associated with dividends is DRIP, which stands for ‘dividend reinvestment plan’. 

Many companies (though not all) will allow you to receive additional shares of said company in lieu of a cash dividend payment – thus allowing you to ‘reinvest’ the dividends back into the company over time (although you still have to pay tax on them, as mentioned earlier).

Sometimes companies even offer incentives for this, such as a share price discount (eg. 2% from the average share price over a period). These transactions will usually not incur brokerage or trading fees either, which makes dividend reinvestment a popular passive strategy. The real advantage with this is that you are using the dividend to buy more shares, which will then buy even more shares next dividend. It’s basically dollar-cost averaging into the share price, spreading your purchases over time and compounding your dividend payments. 

It’s a strategy well worth considering if you’re a long-term investor keen to harness the power of compound interest. However, some investors prefer to reinvest at a time and price of their choosing, and so prefer to receive the cash dividends.

What’s a dividend cut?

So far so good, but dividends don’t always go up (as we have been reminded of in 2020).

Sometimes when a company is facing financial trouble, it has to cut its dividend. Dividends have to be paid out of profits and free cash flow, so if these dry up, it can put significant strain on a company’s dividend payments.

Investors usually don’t like dividend cuts, as noted above, and will often sell companies that cut or that they believe are likely to cut dividends. This is why you need to use caution when looking at companies with high yields and high payout ratios, as both could be a sign that the market is pricing in that the current dividend isn’t sustainable. This situation is known as a dividend trap and is discussed in more detail below.

That said, some companies have variable dividends (as discussed with Coles earlier), so their dividends are expected to go up and down over time. Dividend changes at companies like this have to be looked at differently because the dividend policy is often more important than the dividend payment. 

Fortescue Metals Group Limited (ASX: FMG) is another good example here. The company targets 50–80% of its full-year net profit after tax, regardless of whether it is more or less than the previous dividend. This is noteworthy because Fortescue generates revenue by selling iron and iron ore, the prices of which can be very volatile.

What about a dividend trap?

A dividend trap is yet another term you’ll hear to describe a dividend stock, and it’s one you don’t want to be on the wrong end of. Essentially, a dividend trap is a stock with a high trailing yield backed by a dividend that proves unsustainable. Investors buy into the stock expecting the yield to continue, only to be ‘trapped’ when the company cuts its yield and the share price falls (which is what usually happens), locking the investor into a painful loss.

A good 2020 example would be National Australia Bank Ltd (ASX: NAB). In 2019, NAB paid out $1.66 in dividend to its shareholders. But as the coronavirus pandemic escalated in 2020, it became very obvious that NAB would be unable to maintain these dividend payments in 2020. But if an investor wanted to take a chance on the trailing yield NAB was ‘offering’ that was consistently north of 10%, they would have been very disappointed. NAB later declared an (annualised) dividend of 60 cents per share – meaning the real yield investors could expect in 2020 was nothing close to 10%. Anyone who bought in expecting the 2019 dividend payments to continue would have fallen for a classic dividend trap.

Do dividends tell you anything about valuation?

True and false symbols accept rejected for evaluation, Yes or No on wood blogs on blue background.

Often investors look at a price-to-earnings (P/E) ratio to see if a stock is trading cheaply or richly. P/E is just price divided by earnings, much like a dividend yield is simply dividend payment divided by stock price. They are both relative measures. P/E tells you how much investors are willing to pay for each dollar a company earns, and dividend yield, roughly, tells you the level of income generation investors expect from a company over time.

Truth be told, on their own, P/E and dividend yield don’t tell you all that much about valuation. However, when you compare them to a company’s own history or to a broader group (like an index or direct industry peers), you can start to see valuation patterns. 

Going back to the NAB example, this was a company that historically didn’t approach a trailing yield of 10% very often at all. So when it did, it was an indication that the shares are no longer worth what investors used to think they were.

There are usually reasons why companies trade with low valuations; in this case, the coronavirus combined with difficult macro-conditions in the banking sector as a whole.

But sometimes, the market’s pessimism is misplaced and a high yield can represent a good chance to lock in a long-term investment. You can see this in action back with the Commonwealth Bank example in 1991.

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