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 will take you behind the scenes and help you understand the company’s angle of dividend payment.
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Why do companies pay dividends?
A dividend is a cash distribution that the company pays from its surplus cash flow after setting aside capital expenditures and cash reserves. By sharing its profits, the management gives returns to its shareholders. The management decides on dividends. Hence, you will see some companies declaring bonus dividends when they have windfall gains.
However, not all companies pay dividends. Only those that enjoy stable cash flows tend to give a percentage of it as a dividend payout. Their dividend growth is directly proportional to the change in cash flow. Why do such companies pay dividends?
If a company keeps hoarding cash, activist shareholders can force the management to distribute the excess cash as dividends. Benjamin Graham, the father of value investing, did the same in the Northern Pipeline affair. He obtained proxies for 37.5% of the company’s shares and forced the management to distribute spare cash.
How to choose dividend stocks
When you look for dividend stocks, you should look at three things:
- Whether the company’s free cash flow (FCF) is stable or increasing.
- Its dividend-payout ratio and dividend-paying history.
- Its ability (business model and balance sheet) to maintain or grow its FCF in the future.
Considering the above points, here are two Canadian dividend stocks to buy under $50:
- Enbridge (TSX: ENB)(NYSE: ENB): 6.26%
- SmartCentres REIT (TSX: SRU.UN): 5.94%
Enbridge stock: 6.26% dividend yield
North America’s largest pipeline operator has a robust business model that generates increasing cash flow. It earns toll money on volumes of oil and natural gas transmitted through its pipeline. It increases toll money at regular intervals. When the company builds a new pipeline, it creates a new cash flow stream. It sets aside some 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 over three decades. It has even grown its dividend at a 10% average annual rate in the last 27 years.
Enbridge’s DCF growth is slowing as it is becoming difficult to build new pipelines due to environmental concerns. But that will make its existing pipelines more valuable, and Enbridge can charge a higher toll. Moreover, the sector could see consolidation. This means Enbridge could continue paying incremental 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 stable monthly dividends since 2002. The retail REIT builds properties — some for sale and some to earn rent. It has the advantage of having Walmart as its tenant. Walmart accounts for around 25% of SmartCentres’s revenue. This is both good and bad. Walmart attracts more retail tenants, as its stores bring foot traffic. But too much concentration 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 broadening its portfolio to include mixed-use properties like residential, offices, and storage facilities. SmartCentres has a dividend-payout ratio of 95%, which is a bit risky, as the management could cut dividends if it falls short of cash. But it has survived the 2009 Financial crisis and the 2020 pandemic without any dividend cuts. This shows the management’s determination to keep its shareholders happy while growing the business.
SmartCentres could continue paying dividends for another decade, as Canada’s house prices rise and more people move to cities. The REIT is currently trading above $31 and has a dividend yield of 5.94%.
