There are plenty of ASX dividend shares that have, or are expected to have, a high dividend yield. Could it be a good idea to focus on buying them?
Firstly, I think it’s a good idea to recognise why a business has a high dividend yield.
Dividend yields
A yield is essentially the product of two things.
One, the dividend payout ratio. In other words, how much of its profit or cashflow is it paying out?
Second, the valuation. This typically refers to a ratio like the price/earnings ratio (p/e ratio).
Why do those two things matter?
The level of those two numbers can tell you quite a lot about an ASX dividend share.
Dividend payout ratio
To pay a dividend, a business has to make a profit. Making a profit is usually a good thing. But how much of a dividend it pays could suggest things.
If it has a low dividend payout ratio, it might suggest that the company believes there are plenty of re-investment opportunities for the business. If a business could make a 20% return, 30% return or more, on retaining that profit and investing it then that would probably be a better long-term choice and create more value.
However, it’s worth noting that some shareholders may prefer management to ‘release’ the franking credits rather than just let them sit there.
A high dividend payout ratio could suggest there isn’t a lot of reinvestment opportunities. You often may see mature businesses, blue chip ASX shares, like Commonwealth Bank of Australia (ASX: CBA) have high dividend yields. In that case, the business may not have much growth potential.
But a high payout ratio may simply mean that a business doesn’t need a lot of capital to keep growing at a decent pace. Two examples here could be Magellan Financial Group Ltd (ASX: MFG) and Dicker Data Ltd (ASX: DDR).
The valuation
The valuation – expensive, cheap or anything in between – that the market puts on a business can have a big impact on the yield.
For example, with a reasonably low valuation, a business can have a high yield. Low valuation may suggest a low growth prospect or perhaps the earnings aren’t expected to be consistent. A high yield could even be expected to be reduced with a dividend cut.
In FY22, excluding franking credits and using CommSec numbers, Magellan is expected to have a 4.5% yield, Adairs is expected to have a 6.2% yield and Fortescue Metals Group Limited (ASX: FMG) is expected to have a 15% yield.
Resource company yields can be particularly tricky because of how volatile profit and the dividends can be. The FY23 Fortescue dividend is not likely to be as big as the FY21 one.
But high valuations can push a yield right down.
Just look at Pro Medicus. In FY22 it’s expected to have a dividend payout ratio of 49%. That’s pretty healthy. However, the FY22 earnings multiple means the forward fully franked dividend yield is just 0.4%.
Concluding thoughts on ASX shares with high dividend yields
If investors want a high level of income, without needing to regularly sell a slice of their shares, then ASX dividend shares could be a solution.
However, ultra high yields can be a warning sign. I’d only go for higher yields if I thought that business can grow profit over the long-term, like Magellan.
I do like to regularly cover some of the ASX dividend shares I think that look at interesting.
