Your guide to dividend investing

Buying dividend shares to earn passive income has re-emerged as the prime investment strategy among ASX investors. It coincides with the end of Australia's long-running low-interest rate environment that favoured growth shares. 

With the spotlight again on income shares, many investors will agree that building a diversified income-based portfolio with dividend-paying ASX shares as the backbone is a beautiful thing. 

But before you kick back, relax and earn money while you're sleeping, there's a bit of learning to do. Knowing what a dividend is and how it works is only half the battle. The true path to financial freedom is understanding how to use dividends to develop a robust income-based strategy. 

Let's unpack the essentials of dividend investing to help you create your own income-based plan.

What is a dividend?

Investing in an ASX stock means you own part of that company. As such, you are entitled to a share of its profits through dividend payments. 

While not all companies pay dividends, those that do fund the payments from long-term cash flow and annual business profits.

Companies pay dividends as cash payments typically distributed to shareholders twice a year (every six months). However, they can also pay dividends monthly, quarterly or annually, and even on a one-off basis in the case of 'special dividends'.

Are dividends a good income strategy?

Investors will add dividend-producing shares to their portfolios for many different reasons. However, achieving a portfolio balance — between dividend shares and growth stocks, for example — will depend on your investment approach, temperament, and life stage. 

Older investors may prefer to play it safer and use the income stream from dividends to fund their retirement outright. Or supplement the aged pension. 

Dividends can help boost portfolio returns in good times and bad. Cash payments aren't as subject to market whims as a share price is. This means 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.

What about growth?

Other investors who wish to minimise tax or are still building a nest egg might like to avoid receiving dividend payments, which are taxable income.

These investors may prefer to see a company reinvest its cash into the business to spur 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 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. The company is simply reinvesting them rather than returning them to you as dividends. We typically refer to these types of companies as growth stocks.

Do share buybacks generate income?

A company may use its free cash to undertake a share buyback instead of paying dividends. Buying back shares is another way to return cash to shareholders without distributing the (taxable) money to them. 

The ownership interest in a company is spread across the company's total shares. The company spreads earnings over a smaller share base by reducing the number of shares outstanding via a share buyback. This way, every remaining share on issue is awarded a larger piece of the company's earnings. This 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 key dividend metrics

Now that you understand how dividends work, it's time to learn about some key metrics you'll see when researching income shares to invest in.

Dividend yield

The most prominent metric is the dividend yield. We calculate this by adding the previous 12 months of dividend payments, 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 determine 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 offer higher yields than others. Examples include banking, consumer staples, and resources sectors. 

Most financial data services provide a 'trailing dividend yield' calculated by dividing the annual dividend paid (usually over the previous 12 months) by today's share price. 

Alternatively, if you know when the company will pay its current or projected next dividend, you can multiply that amount by its frequency of payments (usually two 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 long time and 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 annual dividend to $3.50. By FY23, annual dividends were back up to $4.50.

Payout ratio

Another metric that investors focus on is the dividend payout ratio. We can work it out by dividing the dividend by the company's EPS. 

Although companies don't pay dividends out of earnings (they get paid out of free cash and the profit component of annual earnings), the payout ratio shows how easily the company can afford its dividend.

The lower the payout ratio, the better. Payout ratios above 100% are worth 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 do companies decide dividends?

A company's chief executive officer (CEO) recommends to the board of directors what they believe is an appropriate dividend policy. The board makes the final decision. 

Often, companies do not make this policy public, so investors can only use their dividend history to guide them on what returns to expect each year. 

Most dividend-paying companies aim to increase their dividends over time, but this does depend on their earnings (profits).

Some companies set specific dividend goals, typically based on earnings or cash flow percentage. 

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 may also have to answer to a higher power in the payment of dividends. These companies have their financial positions audited by the government to ensure they can support the broader Australian economy in tough times. 

For example, we saw the Australian Prudential Regulatory Authority (APRA) issue guidance to the big 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.

Key dividend dates

There are a few critical 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 a company releases its half-yearly or annual results to the market through an ASX release.

The ASX release will contain the dividend amount the company will pay per share and 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.

Going ex-dividend

The ex-dividend date is the first trading day upon which an upcoming dividend is not included in a share's price. If you buy the stock before that date, you get the dividend. If you purchase after, you won't be eligible for the dividend. 

The record date is when the company lists all its shareholders to allocate dividend payments. 

To understand this process, it might help to look at a real-life example.

On 22 February 2022, Coles Group issued an ASX release informing investors and the public of its intention to pay a final dividend for the first half of FY 2022 (July to December 2021) of 33 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 31 March to shareholders on record as of 4 March. The ex-dividend date, usually one day before the record date, was 3 March.  

So, if you didn't already own shares of Coles Group and wanted to receive this dividend, 2 March was the last day you could purchase shares eligible for the dividend payment. People might refer to this strategy as 'buying before it goes ex-dividend'. 

Tracking these dates is unnecessary for most investors, particularly those with a long-term view. If you already own the stock, you are entitled to receive the dividend as long as you hold your shares past the ex-dividend date. 

However, if you are looking to buy or sell a share, you should check these dates as they could influence the timing of your transaction.

Dividend harvesting

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 stock. 

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 should fall by the dividend amount once it hits the ex-dividend date. Theoretically, it's a zero-sum game. 

There's also the risk that company news or events in the broader market could move the share price during the holding period. 

While you will generate income from the dividends you collect, you could end up with an offsetting capital loss when you sell the shares. The net benefit may be less than you might hope, and thus, we Fools think investors shouldn't get involved with dividend harvesting.

Dividends, franking, and tax

The Australian Taxation Office (ATO) treats dividend payments as personal income. You must 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.

Dividend-paying shares attract many Australian investors 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 must pay on dividends. It's called franking. 

When a company pays a dividend, it comes from its profits. The government has already taxed those profits at the corporate rate (usually about 30 cents in the dollar).

In many other countries, investors must pay income tax on their dividends regardless of whether the company has already paid corporate tax on the profits. The dividend is essentially taxed twice. This doesn't happen in Australia. 

Our government has adopted the franking system to ensure dividend payments are only taxed once. 

So, if a company's dividend comes from profits 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. You can receive these franking credits as a cash refund if you have no taxable income. As a result, an ASX company's dividend can be worth more to an investor than it might initially appear. 

Some examples

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, Coles dividends come with a 'grossed-up' yield of 4.76%. 

Coles dividends are 100% franked – also known as 'fully franked'. This 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.

Partial franking

Some companies with overseas interests will only pay some tax in Australia (or none) and some tax offshore. These companies usually pay 'partially franked' or 'unfranked' dividends. 

Partially franked dividends acknowledge some tax paid but perhaps not at the total 30% rate. Thus, the franking credit will be less, for example, a 70% franked dividend. An unfranked dividend means the company has paid no tax in Australia, so the investor does not receive a franking credit.  

Other companies, notably REITs, are structured as pass-through entities. They pass much of their income to investors to avoid 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 depends on the ASX shares in question.

Most ASX shares pay two dividends per year. The first is usually called the 'interim dividend' and the other the 'final dividend'. Some companies pay a smaller interim dividend and a more significant final dividend. Others will produce a similar or equal amount. 

A dividend paid outside these parameters is generally called a 'special dividend'. Special dividends can reflect many things. They can be a one-off payment or an ongoing arrangement. 

For example, Rio Tinto Limited (ASX: RIO) paid a one-off special dividend in April 2022. Since Rio was enjoying uncommonly high commodity prices over the period from which this dividend was funded, the company likely declared a special one-off payment to reflect this.

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 to reflect the ongoing compensation it receives as part of the NBN rollout.

Other ASX investment vehicles can pay dividends, such as exchange-traded funds (ETFs) or listed investment companies (LICs) holding ASX shares. The payments are called 'distributions' to reflect their 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 funds on the dividends it receives to the fund's owners (the shareholders) as distributions.

Not all dividends are paid in cash

To complicate things even more, companies don't always pay dividends 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 to break the division into its own public company.

A good example was the spin-off of South32 Ltd (ASX: S32) from its former parent company, BHP Group Ltd (ASX BHP). In 2015, BHP 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 South32 share for each BHP share they owned.

BHP also executed a similar move in 2022, spinning off its petroleum assets into Woodside Energy Group Ltd (ASX: WDS). This time, BHP shareholders received one Woodside Energy share for every 5.534 BHP shares 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 dividend reinvestment plan (DRP)?

You'll frequently hear an acronym associated with dividends: DRP, which stands for dividend reinvestment plan. 

Many companies allow investors to receive additional company shares instead of a cash dividend payment. This enables you to reinvest the dividends 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 buy even more next dividend. It's dollar-cost averaging into the share price, spreading your purchases over time, and compounding your dividend payments. 

Here's a real-world example …

Commonwealth Bank floated on the ASX 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 look 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%. 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 faces financial trouble, it has to cut its dividend. It must pay dividends out of profits and free cash flow, so if these dry up, it can significantly strain the company's financial health.

Investors usually don't like dividend cuts and will often sell companies that cut or are likely to cut their dividends. 

This is why you must use caution when looking at companies with high yields and payout ratios. Both could signify 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. We'll discuss this situation, known as a 'dividend trap', in more detail below.

That said, some companies have variable dividends, expected to go up and down over time. Investors must consider dividend changes at companies like this differently because the dividend policy is often more important than the dividend payment. 

Fortescue Metals Group Limited (ASX: FMG) is a good example here. The company's dividend policy aims to pay out 50–80% of its full-year net profit after tax (NPAT) 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, directly affecting 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 an unsustainable dividend. 

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.

AGL Energy Limited (ASX: AGL) shares are an example of this. In 2020, AGL paid out 98 cents per share in dividends to its shareholders. But as the business continued to struggle, it became clear that AGL might struggle to maintain these payouts at that level. 

This caused the share price to decline while the trailing dividend remained. Subsequently, the dividend yield rose to more than 11%.

Therefore, investors who bought AGL in early 2021 expecting an 11% yield would have been disappointed. AGL declared an (annualised) dividend of 75 cents per share for 2021 – meaning the actual yield investors received in 2021 was far lower than 11%. 

Anyone who bought in expecting the 2020 dividend payment to continue would have fallen for a classic dividend trap.

Do dividends tell you anything about valuation?

Often, investors look at the 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.

On their own, the P/E and dividend yield don't tell you all that much about valuation. However, you will see valuation patterns when you compare them to a company's history or a broader group like an index or direct industry peers. 

Going back to the AGL example, this company historically didn't reach anywhere near a trailing yield of 11%. So when it did, it indicated that the shares were no longer worth what investors had previously paid for them.

There are usually reasons why companies trade with low valuations. The coronavirus and difficult macro conditions in the banking sector contributed to this case.

Sometimes, the market's pessimism is misplaced, and a high yield can represent an excellent chance to lock in a long-term investment. 

Investors should always look to know the businesses they own shares in and not simply take their cues from market movements. 

• Additional reporting: Rhys Brock