Dividend Investing in Australia: A Beginner’s Guide

Investing legend Peter Lynch said in his book, Beating the Street: "The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 to 20 years in a row."

Dividend investing is a strategy that involves buying shares of companies that pay regular dividends to their shareholders. Dividends are cash payments that represent a portion of the company’s profits, and they can provide a steady source of income and capital growth for investors.

It’s not only single companies that pay dividends. You can receive dividends from managed funds, LICs or ETFs, although they are called distributions in ETF land.

Let’s look at the basics of dividend investing in Australia, including:

• What are dividends and how do they work?
• What are the benefits and risks of dividend investing?
• How to find and evaluate dividend stocks in Australia?
• How to build and manage a dividend portfolio?

What are dividends and how do they work?

A dividend is a payment of profit made from a company to its shareholders. It is issued based on the number of shares you own. If a company pays a dividend of 10 cents per share, and you own 1000 shares, you will receive $100 in dividends.

Dividends are usually paid out on an annual or semi-annual basis, but some companies may pay dividends monthly, quarterly, or even on a one-off basis (called special dividends).

Dividends are funded from the company’s long-term cash flow and the profits they make each year. However, not all companies pay dividends. Some companies may decide to skip or delay dividend payments if they are having a financially difficult year, or if they want to reinvest their profits back into the business to fuel further growth. Tesla doesn’t pay dividends, as it prefers to reinvest its cash into innovation and expansion.

What are the benefits and risks of dividend investing?

Dividend investing has many benefits for investors, such as:

Income generation: Dividends can provide a regular and reliable source of income for investors, especially for those who are retired or looking for passive income. Dividends can also help investors cope with inflation, as some companies may increase their dividends over time to reflect their growing earnings and value.

Capital growth: Dividends can also contribute to capital growth, as reinvesting dividends can increase the number of shares you own, which can boost your future returns. Additionally, dividend stocks tend to be less volatile than non-dividend stocks, as they are usually backed by established and profitable businesses that have loyal customers and strong competitive advantages.

Tax advantages: Dividends in Australia may come with tax benefits, as some dividends may be franked or partially franked. This means that the company has already paid tax on its profits before distributing them as dividends, and the shareholders can claim a tax credit for the amount of tax paid by the company. This can reduce or eliminate the tax liability on the dividends received by the shareholders. Seek advice from a tax professional for details pertaining to your own personal circumstances.

Dividend investing also has some risks that investors should be aware of, such as:

Dividend cuts: Dividends are not guaranteed, and companies may reduce or suspend their dividend payments if they face financial difficulties or strategic changes. This can result in a loss of income and a drop in share price for investors. You should always monitor the financial health and performance of the companies you invest in, and diversify your portfolio across different sectors and industries.

Dividend traps: Don’t make the mistake of taking the dividend yield on face value. Dividend traps are stocks that offer very high dividend yields (the annual dividend divided by the share price) that may seem attractive to investors, but are actually unsustainable or indicative of underlying problems.

The calculation behind dividend yield is backward looking because is it based on the last dividend divided by the current share price.

A company may have a high dividend yield because its share price has fallen significantly due to poor earnings, declining market share, or legal issues. They may not be able to maintain their dividend payments in the long run, and may end up cutting or eliminating their dividends altogether.

Opportunity cost: Dividend investing may also involve an opportunity cost, as investing in dividend stocks may mean missing out on other potentially more profitable opportunities. For example, some growth stocks that do not pay dividends may offer higher returns in terms of capital appreciation than dividend stocks. Therefore, investors should always weigh the trade-offs between income and growth when choosing their investments.

How to find and evaluate dividend stocks in Australia?

Finding and evaluating dividend stocks in Australia can be challenging, as there are over 2000 companies listed on the Australian Securities Exchange (ASX), but not all of them pay dividends. Moreover, not all dividend stocks are created equal, as some may offer higher yields, more stability, or more growth potential than others.

Therefore, investors should use various criteria and metrics to screen and analyse dividend stocks in Australia, such as:

Dividend yield: Dividend yield is the annual dividend divided by the share price. It measures how much income an investor can expect to receive from a stock relative to its price. A higher dividend yield may indicate a more attractive investment, but it may also reflect a lower share price due to poor performance or prospects. Therefore, investors should not rely solely on dividend yield, but also consider other factors such as earnings, cash flow, and growth.

Dividend history: Dividend history is the track record of a company’s dividend payments over time. It shows how consistent, reliable, and growing the company’s dividends are. A longer and stronger dividend history may indicate a more stable and profitable business that can sustain and increase its dividend payments in the future. Therefore, investors should look for companies that have paid dividends for at least five years, and preferably have increased their dividends over time.

Dividend payout ratio: Dividend payout ratio is the percentage of a company’s earnings that is paid out as dividends. It measures how much of the company’s profits are distributed to shareholders, and how much is retained for reinvestment. A lower dividend payout ratio may indicate a more conservative and sustainable dividend policy, as it leaves more room for the company to grow its earnings and dividends in the future. However, a higher dividend payout ratio may indicate a more generous and attractive dividend policy, as it shows the company’s commitment to rewarding its shareholders. Therefore, investors should look for companies that have a dividend payout ratio between 40% and 80%, depending on the industry and growth stage of the company.

Dividend growth rate: Dividend growth rate is the annual percentage change in a company’s dividend per share. It measures how fast the company’s dividends are increasing over time. A higher dividend growth rate may indicate a more dynamic and prosperous business that can generate higher earnings and cash flow, and share them with shareholders. Therefore, investors should look for companies that have a positive and consistent dividend growth rate over time.

How to build and manage a dividend portfolio?

Building and managing a dividend portfolio requires careful planning and execution, as investors need to balance their income and growth objectives, diversify their risks, and monitor their performance. Here are some steps to follow when building and managing a dividend portfolio:

Set your goals: Before investing in dividend stocks, you should have a clear idea of why you are investing, how much income you need or want, how long you plan to invest, and what level of risk you are comfortable with. These factors will help you determine your target portfolio size, asset allocation, investment horizon, and risk tolerance.

Select your stocks: Once you have your goals set, you can start selecting your stocks based on the criteria and metrics discussed above. You should aim to build a diversified portfolio that covers different sectors, industries, geographies, market caps, and growth stages. You should also avoid overpaying for your stocks by comparing their prices to their fair values or intrinsic values.

Consider reinvesting your dividends: One of the best ways to grow your dividend portfolio is to reinvest your dividends into more shares of the same or different companies. This can help you compound your returns over time by increasing your share ownership and future income potential. You can reinvest your dividends manually by using your cash dividends to buy more shares on the market, or automatically by enrolling in a dividend reinvestment plan (DRP) offered by some companies that allows you to receive additional shares instead of cash dividends.

Review your portfolio: You should regularly review your portfolio to check its performance, income generation, risk exposure, and alignment with your goals. You should also monitor the financial health and performance of the companies you invest in, and watch out for any signs of trouble or opportunity. You may need to rebalance your portfolio from time to time by selling some shares or buying new ones to maintain your desired asset allocation or diversification level.

Any advice in this blog post is general financial advice only and does not take into account your objectives, financial situation or needs. Because of that, you should consider if the advice is appropriate to you and your needs before acting on the information. If you do choose to buy a financial product read the PDS and TMD and obtain appropriate financial advice tailored to your needs. Finpods Pty Ltd & Philip Muscatello are authorised representatives of MoneySherpa Pty Ltd which holds financial services licence 451289. Here's a link to our Financial Services Guide.