Why Investing In Us Remains Profitable Despite No Dividends

Why invest in companies that don't pay dividends?

There are many reasons why investors might choose to put their money into companies that don't pay dividends. Dividends are payments made by companies to shareholders in stock, cash or property. They are a way for shareholders to participate in the profits of a company. However, companies that don't pay dividends are typically reinvesting revenues into the growth of the company itself, which can eventually lead to greater increases in share price and value for investors.

Reasons to invest in companies that don't pay dividends

- Reinvesting in the company: Companies that don't pay dividends are often young and growing firms that prefer to reinvest their earnings in their business instead of issuing dividends. This can also create tax advantages for investors. Retained earnings and price appreciation do not require investors to pay any taxes until they sell the stock.

- Share buybacks: Companies that don't pay dividends may instead invest potential dividend payment cash into something known as a share buyback in the open market. If there are fewer shares available in the open market, then the company's earnings per share (EPS) will rise. Share buybacks, by reducing the total number of outstanding shares in the market, also increase the equity percentage that each shareholder owns.

- Attracting investors: Dividend-paying stocks tend to attract investors seeking income from their investments. However, companies that don't pay dividends may be viewed as having more attractive growth prospects.

- Stable earnings: A company with high earnings and a low price will have a low P/E ratio regardless of dividends, and such a stock could be a good buy.

- Book value: Stocks without dividends can still be excellent investments if they sell for below book value. Every company has assets and liabilities on its balance sheet that can be summed to give the book value of the company. Firms that are currently losing money and cannot pay dividends may see their stock prices fall below book value. At the very least, stocks priced below book value make tempting takeover targets.

Companies that don't pay dividends may be reinvesting profits into growth, which can lead to greater share price increases

Companies that don't pay dividends to their shareholders may be reinvesting their profits into growing the business. This can lead to greater share price increases over time.

A company that is still growing rapidly will usually not pay dividends because it wants to invest as much as possible in its future growth. Mature firms that believe they can increase their value by reinvesting their earnings will also choose not to pay dividends.

For example, Google's parent company Alphabet has never paid a dividend. Instead, it has chosen to reinvest its profits into expanding into new ventures, which has provided shareholders with excellent returns. Similarly, Warren Buffett's Berkshire Hathaway has never paid a dividend since he took over in 1965. Over that period, investors in Berkshire Hathaway have earned a compound annual return of over 20%.

Some companies may also choose to buy back their stock instead of paying dividends. A firm will buy back stock when it has excess cash, and management believes the market undervalues the shares. This can also increase the share price.

However, it's important to note that not all companies that don't pay dividends are doing so for positive reasons. Sometimes, it could be a sign that the company is struggling and is unable to afford to pay dividends. Therefore, it's crucial to evaluate the company's growth history and overall financial health before making an investment decision.

Non-dividend-paying companies may be more attractive to investors from a tax perspective

Secondly, companies that do not pay dividends reinvest their profits back into the business, which can lead to significant growth in stock value over time. This can result in higher returns for investors when they eventually sell their shares. For example, Amazon's stock price has grown from around $30 in October 2000 to roughly $3,286 in October 2020, demonstrating the potential for substantial capital gains.

Additionally, non-dividend-paying companies often focus on reinvesting earnings to fund other projects and fuel internal growth. This strategy can lead to higher returns for investors through a rising stock price. Smaller companies and large caps may pursue this approach, aiming to provide greater returns to shareholders through reinvestment.

Moreover, non-dividend-paying companies may choose to use their net profits for share buybacks in the open market, reducing the total number of outstanding shares. This increases the equity percentage owned by each shareholder and can enhance the potential for capital gains.

In summary, investors who prioritise tax efficiency may find non-dividend-paying companies more attractive due to the ability to defer taxes, the potential for higher capital gains, and the focus on reinvesting earnings to drive stock price appreciation.

Companies that don't pay dividends may be using their profits to pay down debt or reinvest in the business

Reinvesting earnings can also be a way for a company to avoid the potentially high costs associated with issuing new stock. Furthermore, a company's management team might not want to be constricted by a dividend policy and may instead opt for the residual method, which allows them to pursue opportunities without being tied down by consistent payouts.

Additionally, companies that don't pay dividends may be offering investors tax advantages. Non-qualified dividends are taxable to investors as ordinary income, which means an investor's tax rate on dividends is the same as their marginal tax rate. Marginal tax rates can be as high as 37%. For qualified dividends, on the other hand, the tax rate is either 0%, 15%, or 20%, depending on the marginal income tax bracket that the investor falls under.

Non-dividend-paying companies may be acquiring other companies or investing in research and development

Companies that don't pay dividends typically reinvest their profits back into the business, which can lead to accelerated growth and increased share prices. This strategy is often favoured by younger, high-growth companies that are looking to scale operations and expand their business. By retaining earnings, these companies can fund new growth opportunities, such as acquisitions, expansion, and product development.

For example, Amazon has never paid dividends to its shareholders, instead choosing to reinvest profits back into the business to fund new products, ideas, and services. As a result, Amazon's stock price has grown significantly over the years, providing investors with substantial capital gains.

Additionally, companies that don't pay dividends may be looking to acquire other companies. For instance, Warren Buffett, the chairman and CEO of Berkshire Hathaway, is well-known for his acquisition strategy. He has spoken out against paying dividends, stating that money can be spent better in other ways, such as reinvestment and acquisitions. By acquiring other companies or purchasing ownership stakes, these non-dividend-paying companies can increase their market share and potentially drive up their stock prices.

Companies that don't pay dividends may be buying back their own shares, which can increase the value of the remaining shares

A stock buyback is when a company uses its cash to buy back shares of its own stock on the open market. This can be done to return money to shareholders that the company doesn't need to fund operations and other investments. By reducing the number of shares available on the market, the value of the remaining shares increases.

For example, consider a company with a total of 200 shares. If they do a share buyback of 100 shares, so that there are only 100 shares left, a shareholder who owns 10 shares will then own a 10% equity interest in the company, whereas before the buyback, their 10 shares represented only a 5% equity interest.

Share buybacks can also be used to offset dilution caused by issuing stock options to retain employees.

There are some disadvantages to stock buybacks. They may privilege short-term gains in share price when other more profitable uses of the cash are available, such as investing in research and development. They can also be a poor use of cash if a company takes on debt to finance the buyback.

Overall, companies that don't pay dividends may be choosing to reinvest their earnings into the company's growth, which can lead to greater increases in share price and value for investors over time.

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