1. Invest in companies with sustainable dividends
When it comes to investing in companies for long-term wealth, go no further than those that have a sustainable business model that supports a growing stream of dividends.
Over time, the dividends from Commonwealth Bank (ASX: CBA) have consistently increased, which has resulted in an increasing share price. As a consequence, the share price has risen 120% over the last five years.
2. Identify high dividend-paying companies
This is a trap for young players. Dividend yield should not be looked at in isolation. A high yield may indicate a recent share price tumble due to earnings concerns. Applying a historical dividend against a low share price doesn't take into account any imminent lowering of that dividend.
To avoid this trap, investors should familiarise themselves with forecast earnings-per-share growth in the years ahead. This will indicate those companies with growth and dividend sustainability.
3. Invest for the long term
Australian dividends have on average grown at 7% per year. By reinvesting dividends over the past 30 years, the total investment return has increased nearly 400%.
In a prior article on the secret to accumulating wealth, I discussed the Rule of 72. In short, should an investor hold a stock for 10 years, a dividend of 7.2% per annum would be required to double the original investment.
4. Make use of franked shares
The abovementioned additional 400% return from dividend re-investment is underestimated as it does not take into account dividend franking. The franking credit on a fully franked share accounts for over 40% of the total dividend.
A better measure is gross dividend yield. This is calculated by adding franking credits paid over the last 12 months to total dividends and then dividing by the share price.
While franking is a great feature for dividend investors, one should never make an investment based on tax reasons alone.
5. Avoid the majority of low-cap high yield stocks
Thorough research on small-cap stocks may reveal some high-yielding gems. However, downside risks include scant analysis by the investment community, a lower level of transparency and low stock liquidity.
6. Dividend re-investment plans (DRPs) — Is the stock underpriced?
DRPs are an issue of shares by a company to an equivalent value of the dividend. DRPs are an important way to maximize your dividend returns. Mostly stock is offered at a small discount to the prevailing price, and broker commissions are avoided. Surprisingly, some companies such as Telstra (ASX: TLS) don't offer DRPs.
A decision needs to be made on the DRP at dividend time to determine the value — is it the best use of funds or do other stocks a better value proposition?
7. Am I adequately diversified?
If your portfolio is small or not well diversified, it may not be prudent to add to existing holdings via a DRP. The best use of the dividend in this case is to invest in other undervalued stocks.
8. Is the company issuing new shares to fund the DRP?
DRPs, capital raisings and option issues are just some ways that the interests of non-participating shareholders may be diluted. Should a company regularly increase the number of shares on issue, even your existing holdings may not be a good investment.
9. Invest in shareholder-friendly companies
There are many examples of investor's interests being aligned with those of a company. Westpac Banking Corporation (ASX: WBC) buys shares on market and then transfers them to DRP participants. Share buy backs are used by other companies to offset the dilutionary effects of DRPs.
10. Will your personal psychology torpedo the overall aim?
Your best intentions of maximizing your dividend returns may be undermined by personal idiosyncrasies.
For simplicity it may be preferable to buy a listed investment company (LIC) with a DRP to achieve compounding returns. Australia's biggest listed investment company (LIC) is Australian Foundation Investment Company (ASX: AFI).
Foolish takeaway
A disciplined approach to stock selection and dividend re-investment is paramount to maximising your dividend income. Each requires an objective assessment of the value on offer at the time of the investment decision.
