You must have heard a lot about dividends and how they generate passive income. But do you know how companies decide on dividends and pay them? In this article, I’ll take you behind the scenes and help you understand the company’s dividend payout angle.

Why do companies pay dividends?

A dividend is a cash distribution that the company pays out of its excess cash after setting aside capital expenditures and cash reserves. By sharing its profits, management reports to its shareholders. Management decides on dividends. Therefore, you will see some companies declaring bonus dividends when they have windfall gains.

However, not all companies pay dividends. Only those with stable cash flow tend to pay out a percentage of it as a dividend. The growth of their dividend is directly proportional to the variation in cash flow. Why do these companies pay dividends?

If a company continues to hoard cash, activist shareholders can force management to distribute excess cash as dividends. Benjamin Graham, the father of value investing, did the same in the Northern Pipeline case. He obtained proxies for 37.5% of the company’s shares and forced management to distribute excess cash.

How to choose dividend stocks

When looking for dividend stocks, you need to consider three things:

• Whether the company’s free cash flow (FCF) is stable or increasing.
• Its dividend payout ratio and dividend payout history.
• Its ability (business model and balance sheet) to maintain or grow its FCF in the future.

Considering the points above, here are two Canadian dividend stocks to buy under $50:

Enbridge stock: 6.26% dividend yield

North America’s largest pipeline operator has a robust business model that generates growing cash flow. It collects tolls on the volumes of oil and natural gas transported through its pipeline. It raises the tolls at regular intervals. When the company builds a new pipeline, it creates a new cash flow. It sets aside cash to build and maintain pipelines and pays out 60-70% of distributable cash flow (DCF) as dividends.

The business model has helped Enbridge successfully pay regular quarterly dividends for more than three decades. It even increased its dividend at an average annual rate of 10% in last 27 years.

Enbridge’s DCF growth is slowing as it becomes difficult to build new pipelines due to environmental concerns. But it will increase the value of its existing pipelines and Enbridge will be able to charge a higher toll. In addition, the sector could experience consolidation. This means that Enbridge could continue to pay additional dividends for another decade or two. The stock is currently trading above $43 and has a dividend yield of 6.26%.

SmartCentres REIT: 5.94% dividend yield

SmartCentres REIT has been paying steady monthly dividends since 2002. The commercial REIT builds properties, some for sale and some for rent. It has the advantage of having walmart as its tenant. Walmart accounts for approximately 25% of SmartCentres revenue. This is both good and bad. Walmart attracts more retail tenants as its stores generate foot traffic. But too much focus on one customer increases the risk if the customer decides to leave. You can only hope that day never comes.

SmartCentres is trying to mitigate the risk by expanding its portfolio to include mixed-use properties such as residences, offices and storage facilities. SmartCentres has a dividend payout ratio of 95%, which is a bit risky as management could cut dividends if they run out of cash. But it survived the 2009 financial crisis and the 2020 pandemic without any dividend cuts. This shows management’s determination to satisfy its shareholders while growing the business.

SmartCentres could continue to pay dividends for another decade as Canadian home prices rise and more people move to cities. The REIT is currently trading above $31 and has a dividend yield of 5.94%.