Many new investors wonder whether a stock is worth buying if it does not pay dividends. After all, if it doesn't, aren't you counting solely on what the next guy in line is willing to pay for your shares?
It's true that dividends are a great source of return for shareholders, especially when combined with dollar-cost averaging. But a company doesn't need to pay out dividends to be worth investing in.
The following story is meant to help explain non-dividend-paying stocks and how they can benefit your portfolio. Let's look at why re-investing profits instead of distributing dividends can work out very well for shareholders as the value of the shares increases.
A dividend is a portion of a company's earnings, which its board of directors decides to pay to its shareholders.
The Creation of Investor Stock Shares
Imagine that your father and your uncle decide that they want to start a farming business. They each contribute $150,000 of their savings to their new company, American Apple Orchards Inc. They divide the company into 100,000 pieces ("shares") at $3 per share, with each man receiving half of the stock for his contribution.
The new company uses the combined $300,000 to secure a $700,000 business loan. This gives them $1 million in cash and $700,000 in debt with a $300,000 net worth (consisting of their original contribution to the company).
The company buys 300 acres of good farmland at $2,500 per acre ($750,000 total) and uses the remaining $250,000 for equipment, working capital, and startup costs. The first year, the farm generates $43,000 in pretax operating profit. After taxes, this amounts to $30,000.
At the end of the year, your father and uncle are sitting at the kitchen table, holding the board of directors meeting for American Apple Orchards Inc. They see that the annual report the accountant prepared shows $300,000 in shareholder equity at the beginning, with a $30,000 net profit, for $330,000 ending shareholder equity.
In other words, for all of their effort, they earned $30,000 on their $300,000 investment. Instead of cash, however, the assets consist of farmland, apple trees, tractors, and other items. That is a 10% return on book value. If interest rates are 4% at the time, this is a good return. Not only did your family earn a good return on their investment, but your father and uncle got to live their dream by farming apples.
But your father and uncle realize that the accountant left something else important out of the annual report: Real estate appreciation.
If inflation ran 3%, the farmland probably kept pace, meaning that the appreciation was $22,500. In other words, if they sold their farm at the end of the year, they would get $772,500, not the $750,000 they paid, generating a gain on real estate of $22,500. When you add that to the $30,000 in operating profits, that means their real return for the year was roughly $52,500, or 17.5%. (To be fair, you would have to back out deferred taxes for the money that would be owed if they were to sell the land, but we'll keep it simple.)
When Companies Pay Dividends
Now, your father and uncle have a choice. They have a business that has $330,000 in book value but that they know is worth $352,500 ($300,000 contributed capital plus $30,000 net profit plus $22,500 appreciation in the land). So the accountant says their shares are worth $3.30 each ($330,000 divided by 100,000 pieces), but they know their stock is actually worth $3.52 per share ($352,000 divided by 100,000 pieces).
Do they pay the $30,000 in cash they earned out as a $0.30 per share dividend ($30,000 net income divided by 100,000 shares equals $0.30 per share)? Or do they turn around and pour that $30,000 back into the business to expand? If the orchard can earn 10% on capital again next year, profits should increase to $33,000. Compared to the 4% the local bank pays, wouldn't they be better off not paying out that money as a cash dividend and, instead, going for the 10% return?
A company can use any money not paid in dividends to generate new profits and increase long-term value to its shareholders.
Compounding The Dividend Decision
Imagine that this conversation happens every year for the next 20 years. Every year, your father and uncle decide to reinvest the profit instead of paying a cash dividend, and each year they earn 10% on capital. The real estate also appreciates 3% per year. The entire time, they never issue, buy, or sell a share of their company's stock.
On the company's 20th anniversary, net income is going to be $201,800. Book value, representing profits poured back into the company for expansion, would have grown from $300,000 to $2 million. On top of that $2 million, though, is the real estate. The land would have appreciated $645,000 from the first day of operation—not one penny of which has ever shown up anywhere in the financial statements. Thus, the true value of the business is at least $2,645,000.
Book Value vs. Real Value
From a book value perspective, the shares of the company are worth $20 each ($2 million book value divided by 100,000 shares). From a "real" value perspective, factoring in the value of the land, the shares are worth $26.45 each ($2,645,000 divided by 100,000 shares).
If the company were to pay out 100% of its profits in cash dividends, they would be just shy of $2.02 per share ($201,800 net profit for the year divided by 100,000 shares equals $2.02 per share cash dividends).
In practical terms, that means that the $300,000 your father and uncle invested into American Apple Orchards Inc. when it was founded 20 years ago has grown to $2,645,000. In addition, the company generates $201,800 in net income each year. A reasonable, fair valuation of the stock when factoring in real estate appreciation is $26.45 per share.
Putting It Together
You want nothing more than to go into business with your father. You decide to approach your uncle and offer to buy his 50,000 shares, representing 50% of the business.
In the 20 years since the company has existed, not a single penny has been paid out to the stockholders as a cash dividend. Would you seriously approach your uncle and offer to buy his shares at the original $3 purchase price when he and your father founded the company? Or would you offer to buy his shares at their current value of $26.45?
In other words, if you paid $1,322,500 for 50% of a $2,645,000 farm, do you really think your uncle would feel like he was part of a Ponzi scheme because the money had been reinvested over the years? Of course not. Your money represents real assets and earning power. Even though your uncle didn't take those profits over the years, it has represented a real, and tangible, gain in net worth for your family.
An Example From Wall Street
On Wall Street, the same holds true for huge companies. Take Berkshire Hathaway, for example. The stock has gone from $7.50 to as much as $347,400 per share over the past 55-plus years because Warren Buffett has reinvested the profits into other investments. When he took over, the company owned nothing but some unprofitable textile mills. Today, Berkshire owns large chunks of great companies including American Express, Apple, Procter and Gamble, and many more.
Is Berkshire worth $200,000 or more per share? Absolutely. Even if it doesn't pay out those earnings now, it has hundreds of billions of dollars in assets that could be sold and that generate tens of billions of dollars in profit each year. That has value, even if the shareholders don't get the benefit in the form of a cash dividend. The board of directors could literally turn on the spigot and start paying massive dividends tomorrow.
In developed nations, with strong financial markets, the stock market will recognize this gain in value by rewarding a company with a higher market price. Of course, this is irregular and can take years. But if you bought $8,000 worth of Berkshire years ago, your 1,000 shares are now worth $264,280,000 (as of May 2020). If you desired, you could sell off several million dollars worth of stock, or put the shares in a brokerage account and take a small margin loan against them, to fund your lifestyle needs. In effect, you could create your own dividend.