Many new investors wonder whether stocks are worth buying if they don’t pay dividends. After all, if they don’t pay, are you just relying on what the next person wants to pay for your shares?
It is true that dividends are a great source of return for shareholders, especially when paired with dollar-cost averaging. However, a company does not need to pay dividends to be worthy of investment.
Definition
Dividends are a portion of a company’s earnings that its board of directors decides to pay out to shareholders.
Creating Investor Shares
Imagine your father and uncle decide that they want to start an farming business. Each contributes $150,000 of their savings into their new company, American Apple Orchards Inc. They divide the company into 100,000 sections (“shares”) valued at $3 per share, with each man receiving half of the shares in return for his contribution.
The new company uses the total amount of $300,000 to secure a business loan of $700,000. This gives them one million dollars in cash and $700,000 in debt, with a net asset value of $300,000 (consisting of the original contributions 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 to purchase equipment, working capital, and startup costs. In the first year, the farm generates $43,000 in operating profit before tax. After taxes, that becomes $30,000.
At the end of the year, your father and uncle sit at the kitchen table holding a board meeting for American Apple Orchards Inc. They see in the annual report prepared by the accountant that there is $300,000 in shareholder equity at the beginning, with a net profit of $30,000, bringing the total shareholder equity to $330,000.
In other words, they made $30,000 on their $300,000 investment. Instead of cash, the assets consist of farmland, apple trees, tractors, and other items. This is a 10% return on book value. If interest rates were 4% at that time, this is a good return. Not only did your family earn a decent return on their investment, but your father and uncle also managed to realize their dream of apple farming.
But your father and uncle realize that the accountant left something else important out of the annual report: the property appreciation.
If inflation is 3%, it’s likely that the farmland keeps pace with it, meaning that the appreciation was $22,500. In other words, if they sold their farm at the end of the year, they would receive $772,500, not just the $750,000 they paid, generating a property gain of $22,500. When this value is added to the operating profit of $30,000, it means that their real return for the year was about $52,500, or 17.5%. (To be fair, you should deduct the deferred taxes on the amounts that would be due if they decided 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 company with a book value of $330,000, but they know it 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 per share ($330,000 divided by 100,000 sections), but they know the actual price of their share is $3.52 per share ($352,000 divided by 100,000 sections).
Should they pay the $30,000 of cash they received as a dividend of $0.30 per share ($30,000 net income divided by 100,000 shares equals $0.30 per share)? Or should they go back and reinvest that $30,000 into expanding the business? If the orchard can earn 10% on the capital again next year, the dividends should increase to $33,000. Compared to the 4% interest the local bank pays, wouldn’t it be better not to pay that money as dividends and instead aim for a 10% return?
Accumulation
Profit Decision
Imagine this conversation happening every year for the next 20 years. Each year, your father and uncle decide to reinvest the profits instead of paying cash dividends, and each year they earn 10% on the capital. The properties also appreciate by 3% annually. Throughout this period, they neither issued nor bought or sold any shares of their company.
By the 20th anniversary of the company, the net profits will amount to $201,800. The book value, which represents the profits reinvested in the company for expansion, will have increased from $300,000 to $2 million. In addition to the $2 million amount, there are the properties. The land will have appreciated by $645,000 from the first day of operations – none of which has appeared in any financial statements. Thus, the true value of the company is at least $2,645,000.
Book Value vs. True Value
From the perspective of book value, the company’s shares are worth $20 per share ($2 million book value divided by 100,000 shares). From the perspective of true value, taking into account the land value, the shares are worth $26.45 per share ($2,645,000 divided by 100,000 shares).
If the company paid 100% of its profits as cash dividends, it would be around $2.02 per share ($201,800 net profit for the year divided by 100,000 shares equals $2.02 per share as cash dividends).
Practically, this means that the $300,000 invested by your father and uncle in American Apple Orchards Inc. when it was founded 20 years ago has grown to $2,645,000. Additionally, the company generates $201,800 in net income every year. The fair estimate of the share, considering the property appraisal, is $26.45 per share.
Putting It Together
You want nothing more than to enter into business with your father. You decide to approach your uncle and offer him to purchase 50,000 shares from him, representing 50% of the company.
In the 20 years since the company’s founding, no single penny has been paid to shareholders as cash dividends. Will you seriously approach your uncle and offer to buy his shares at the original purchase price of $3 when the company was established by him and your father? Or will you suggest to him to sell his shares at their current value of $26.45?
In other words, if you paid $1,322,500 for 50% of a farm worth $2,645,000, do you really think your uncle will feel it’s part of a Ponzi scheme because the profits have been reinvested over the years? Of course not. Your money represents real assets and earning potential. Although your uncle did not take those profits over the years, they represent a genuine gain in net worth for your family.
Example from Wall Street
On Wall Street, the same rule applies to large companies. Take Berkshire Hathaway as an example. The stock price rose from $7.50 to over $347,400 per share over more than 55 years because Warren Buffett reinvested the profits into other investments. When he took over the company, it only owned some unprofitable textile factories. Today, Berkshire holds large stakes in 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 didn’t pay those dividends now, it owns hundreds of billions of dollars in assets that can be sold and generate tens of billions of dollars in profits each year. It has value, even if shareholders are not receiving benefits in the form of cash dividends. The board could simply turn on the tap and start paying huge dividends tomorrow.
In
Developed countries, with strong financial markets, will recognize this increase in value in the stock market by rewarding the company with a higher market price. Of course, this is irregular and
Source: https://www.thebalancemoney.com/value-of-stocks-without-dividends-357450
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