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. Knowing what a dividend is and how dividends work is only half the battle. Knowing how to make the best use of dividends can put you on the path to true financial freedom.
This guide covers the essentials of dividend investing to help you create your own dividend portfolio strategy.
What is a dividend?
An investment in an ASX stock means you own part of that company and are therefore entitled to a share of its profits in the form of dividends.
Dividends are funded from the company’s long term cash flow and the profits they make each year.
Dividends are cash payments distributed to shareholders at regular intervals, with semiannual payments (every 6 months) the most commonly chosen interval in Australia. However, dividends can also be paid monthly, quarterly or annually, and even on a one-off basis in the case of ‘special dividends’.
Are dividends a good thing?
For some investors, dividends are great… for others, dividends are a nuisance. It just depends on your investment approach and temperament.
For example, some investors use their dividends to fund their retirement outright or 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 market whims like a share price is – meaning 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.
Other investors – those who wish to avoid tax or are still building a nest egg – might prefer not to receive dividend payments, which are taxable income.
These investors might prefer to see a company reinvest its cash into the business to spur higher levels of growth and profits over the long term.
Why? Because each dollar paid out as a dividend is a lost opportunity for the company to invest and grow the business. If a company can get a return on invested capital of 15%, each dollar paid out in one year would be worth a tax-free $1.15 within the company by the following year, if it was reinvested. Then it would compound to $1.32 in the year after that, and so on.
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 as dividends. These types of companies are often referred to as growth stocks.
Some investors might also prefer to see a company use free cash to undertake a share buyback instead of paying dividends. Buying back shares is another way in which companies can return cash to shareholders without actually distributing the (taxable) money to them.
The ownership interest in a company is spread across the total number of shares the company issues. By reducing the number of shares outstanding via a share buyback, the company gets to spread earnings over a smaller share base. This way, every remaining share on issue is awarded a larger piece of the company’s earnings, which increases earnings per share (EPS).
Since earnings are a key metric by which investors grade a company’s success, higher earnings generally lead to higher share prices.
Some companies like to use share buybacks because they don’t actually have to complete them, even if they announce them. This provides more flexibility in case the business environment changes or a company’s share price fluctuates in value.
Some key dividend metrics
Now that you’ve got an understanding of how dividends work, it’s time to learn about some of the key metrics you’ll see when researching dividend shares.
The most prominent metric is the dividend yield. This is generated by adding together the previous 12 months of dividend payments (often 2 payments, one large and one small), and then dividing by the current share price.
The higher the yield, the better for 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 share'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 peer companies, as some industries tend to offer higher yields than others. Examples include banking, consumer staples and resources.
Most financial data services provide a ‘trailing dividend yield’, which is calculated by dividing the total annual dividend paid (usually over the previous 12 months) by today’s share price.
Alternatively, if you know the current or projected next dividend to be paid, you can multiply that amount by the company’s frequency of payments (usually 2 per year) and divide by today’s share price to determine the ‘forward dividend yield’.
Yield on purchase price
Some investors will also look at the yield on purchase price. You calculate this by taking the current annual dividend per share and dividing it by your average cost per share. This is specific to each individual investor. It is most appropriate for investors who have owned a dividend-paying share for a very long time and/or for those who have used dollar-cost averaging to create their position.
For example, if you had purchased Commonwealth Bank of Australia (ASX: CBA) when it first floated in 1991 for $5.40, you would have received a starting annual dividend of 40 cents per share. That’s a 7.4% starting dividend yield (very strong!).
By 2019, the dividend had grown to $4.31 per share. That’s a yield on cost, or purchase price, of 79.8% every year for those lucky investors.
Of course, dividends can rise and fall for many reasons. For example, in 2020, the COVID-19 pandemic meant the banks needed to retain more capital to keep the banking system strong. So, CBA reduced its dividend for 2020 to $2.98. In 2021, as the outlook improved, CBA raised its dividend to $3.50.
Another metric that investors focus on is the payout ratio. This can be derived by dividing the dividend by the company’s EPS.
Although dividends don’t get paid out of earnings (remember, they get paid out of the profit component of annual earnings, as well as free cash), the payout ratio gives you an idea of how easily the company can afford its dividend. The lower the payout ratio the better, with ratios above 100% worthy of additional research (noting that some industries, such as real estate investment trusts (REITs), often have payout ratios above 100% because of heavy depreciation expenses).
This figure can be calculated over different time periods, but it is usually looked at semiannually, over the trailing 12 months, or annually.
How are dividends decided?
The chief executive officer (CEO) of a company makes a recommendation to the board of directors on what they believe is an appropriate dividend policy. The board makes the final decision.
Often, this policy is not made public, so investors can only use the company’s dividend history to guide them on what returns to expect each year.
Most dividend-paying companies aim to increase their dividends over time, however, this does depend on their earnings (profits).
Some companies do set specific dividend goals, which are usually based on a percentage of earnings or cash flow.
For example, Coles Group Ltd (ASX: COL) aims to pay 80–90% of its earnings as dividends. This gives investors more clarity over time regarding the income they can expect to receive from their shares.
The board of directors is a group of representatives elected by the shareholders. They are above 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.
The other issues a board might look at include the company’s profitability, available cash, leverage, and future capital needs.
Some companies might also have to answer to a higher power in the payment of dividends, too. These companies have their financial positions audited by the government to make sure they are able to support the broader Australian economy in tough times.
For example, we saw the Australian Prudential Regulatory Authority (APRA) issue guidance to the large Australian banks and insurers in April 2020 not to pay substantial dividends due to the impact of the pandemic.
As the level of economic uncertainty abated, APRA updated this guidance in July 2020 and again in December 2020. Today, APRA is no longer holding banks to minimum earnings retention levels.
Some key dividend dates
There are a few key dates for investors each year. Most notable (and most fun) is the declaration date when you find out how much you will receive in a company’s next round of dividend payments.
The declaration date is usually the same day that a company releases its half-yearly or annual results to the market through an ASX release.
The ASX release will contain the dividend amount to be paid per share, as well as the level of franking (a tax credit that we explain further below). It will also state the ex-dividend date, record date and payment date.
The ex-dividend date is the first trading day upon which an upcoming dividend isn’t included in a share’s price. If you buy the stock before that date, you get the dividend. If you buy after, you won’t get the dividend.
The record date is the day the company makes a list of all of its shareholders for the purposes of allocating dividend payments.
To understand this process, it might help to look at a real-life example.
On 18 August 2020, Coles Group issued an ASX release informing investors and the public of 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 ex-dividend date, which is usually one day before the record date, was 27 August.
So, if you didn’t already own shares of Coles Group, and you wanted to receive this dividend, 26 August was the last date you could purchase shares that were eligible for the dividend payment. You might hear people refer to this strategy as ‘buying before it goes ex-dividend’.
For most investors, particularly those with a long-term view, it is not necessary to track these dates. You already own the stock, so whenever the dividend is announced, you will be entitled to receive it as long as you hold your shares past the ex-dividend date.
However, if you are looking to buy or sell a share, you might want to check these dates as they might influence the timing of your transaction
Some investors try to ‘harvest’ dividends by investing around these dates. Dividend harvesting (also called dividend ‘capturing’) is a strategy whereby investors only hold shares long enough to ensure their entitlement to the next dividend payment before selling and moving on to another share.
In this way, harvesters can invest in many dividend shares with the same money and ‘capture’ more dividends. Although this sounds like a great idea, it is complicated and time-consuming.
The biggest complication is that the share price typically falls on the day the share goes ex-dividend. This is because dividends are essentially a return of retained earnings, or 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 share price could be moved by company news or events in the broader market during the holding period.
While you will generate income from the dividend you collect, you could end up with an offsetting capital loss when you sell the shares. It’s 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
Dividend payments are usually treated as personal income by the Australian Taxation Office (ATO). You will have to declare any dividend income you receive during the financial year when you do your annual tax return.
Even if you decide to reinvest those dividends into more shares through a ‘dividend reinvestment plan’ (DRP) (more on that later), the ATO will still treat this reinvestment as if you’d received the payments in cash, so you still have to pay tax on them.
Many Australian investors are attracted to dividend-paying shares for another reason – franking credits. These credits reduce your tax liability.
What are franking credits?
Here in Australia, we have a unique way of treating the taxes you have to pay on dividends. It’s called ‘franking’.
When a company pays a dividend, the money comes out of its profits. Those profits have already been taxed by the government at the corporate rate (usually about 30 cents in the dollar).
In many other countries, investors have to pay income tax on their dividends regardless of whether the company has already paid corporate tax on the profits. This means the dividend is essentially taxed twice. This doesn’t happen in Australia.
Our government has adopted the franking system to make sure dividend payments are only taxed once.
So, if a company’s dividend comes from profits that have been taxed in Australia, shareholders will receive their dividend payment with an acknowledgement of the tax already paid.
This acknowledgement is known as a franking credit, which 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.
For example, if Coles Group pays a 60 cent per year dividend and its share price is $18, then its raw dividend yield is 3.33% per year to an investor who buys Coles shares at $18.
But if you include the value of the franking credits that Coles dividends come with, the ‘grossed-up’ yield is 4.76%.
Coles dividends are 100% franked – also known as ‘fully franked’ – which means Coles has paid tax on 100% of the money distributed as dividends. To calculate the gross yield on a share that pays fully franked dividends, divide the raw dividend yield by 70, then multiply by 100.
Some companies with overseas interests will only pay some tax in Australia (or even none) and some tax offshore. These companies usually pay ‘partially franked’ dividends or ‘unfranked’ dividends.
Partially franked dividends come with an acknowledgement of some tax being paid but perhaps not at the full 30% rate. Thus, the franking credit will be less, for example, a 70% franked dividend. If a dividend is unfranked, then no tax has been paid by the company in Australia, so the investor does not receive a franking credit.
Other companies, notably 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 for investors.
Are all dividends created equal?
Yes and no. It really depends on the ASX shares in question.
Most ASX shares pay 2 dividends per year. The first will usually 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 one-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 a one-off payment.
Other special dividends can reflect the circumstances of the company’s earnings. Telstra Corporation Ltd (ASX: TLS) has paid a special dividend on top of its regular interim and final dividends for years to reflect the ongoing compensation it 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 can also pay dividends. However, they are usually called ‘distributions’ to reflect the indirect nature of these payments.
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 that the fund receives are passed on to the owners of the fund (the shareholders) 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 new company shares rather than cash payments, but 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 into 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 1 South32 share for each BHP share they owned.
These ‘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 DRP?
An acronym that you’ll frequently hear associated with dividends is DRP, which stands for dividend reinvestment plan.
Many companies allow investors to receive additional shares of the company in lieu of a cash dividend payment. This enables you to reinvest the dividends back into the company via an automatic process that increases your shareholdings (although you still have to pay tax on the dividends, as mentioned earlier).
Sometimes, companies even offer incentives for this, such as a share price discount (for example, 2% off the average share price over a period). These transactions will usually not incur brokerage or trading fees, either.
Dividend reinvestment is a popular passive investing strategy. The real advantage 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.
A real-world example will probably help here.
Commonwealth Bank floated on the ASX back in 1991 for $5.40 per share and has paid a semiannual dividend every March and September since.
CBA cracked $100 a share in May 2021. Based on this price, investors would be looking at a 1,751% return since 1991 on capital appreciation alone. Impressive, right? But what if you had also reinvested your dividends?
Investors who used CBA’s DRP to reinvest their dividends have received a far more spectacular return of more than 7,000% 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.
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, so they take their dividends in cash.
What’s a dividend cut?
So far so good, but dividends don’t always go up (as we were reminded 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 the company’s financial health.
Investors usually don’t like dividend cuts, as noted above, and will often sell companies that either cut or are likely to cut their dividends.
This is why you need to use caution when looking at companies with high yields and high payout ratios. Both could be a sign that the market is pricing in the possibility that the current dividend isn’t sustainable.
This might lead to the share price falling and thus, the dividend yield artificially rising. 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’s dividend policy is to aim to pay out 50–80% of its full-year net profit after tax as dividends, 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. These commodities sell at varying prices, depending on global demand, which directly affects Fortescue’s earnings.
What about a dividend trap?
A dividend trap is yet another term you’ll hear to describe a dividend share, 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.
An example of this can be seen with National Australia Bank Ltd (ASX: NAB) shares. In 2019, NAB paid out $1.66 in dividends 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. This caused the share price to decline while the trailing dividend remained, subsequently the dividend yield rose to 10%.
Therefore, investors who bought NAB in early 2020 expecting a 10% yield would have been disappointed. NAB declared an (annualised) dividend of 60 cents per share – meaning the real yield investors received in 2020 was nothing close to 10%. Anyone who bought in expecting the 2019 dividend payment to continue would have fallen for a classic dividend trap.
Do dividends tell you anything about valuation?
Often, investors look at a price-to-earnings (P/E) ratio to evaluate whether a share is trading cheaply or richly. P/E is just price divided by earnings, much like a dividend yield is simply the dividend payment divided by the share price. They are both relative measures.
P/E tells you how much investors are willing to pay for each dollar a company earns. The dividend yield roughly tells you the level of income generation investors expect from a company over time.
Truth be told, on their own, the 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 will start to see valuation patterns.
Going back to the NAB example, this was a company that historically didn’t go anywhere near a trailing yield of 10%. So when it did, it was an indication that the shares were no longer worth what investors had previously paid for them.
There are usually reasons why companies trade with low valuations. In this case, the coronavirus combined with difficult macro conditions in the banking sector contributed.
Sometimes, the market’s pessimism is misplaced and a high yield can represent a good chance to lock in a long-term investment. Investors should always look to know the businesses they own, and not simply take their cues from market movement.
Figures correct as at 7 October 2021. Sebastian Bowen contributed to this article and owns shares of National Australia Bank Limited and 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 owns shares of and has recommended COLESGROUP DEF SET and Telstra Corporation Limited. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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