Why buy stocks that don't pay dividends?

Factual Questions
1

If a stock doesn’t pay dividends, then what connection does it have to the profits of the underlying company? Maybe that company’s profits are going up or down, but either way, your non-dividend-paying stock doesn’t let you get any share of that profits.

Take Google stock. It doesn’t pay dividends now, is unlikely to start paying dividends in the forseeable future, and has 2 classes of stock so that the founders can always out-vote the shareholders (so you can’t even buy all the stock and vote for the company to pay you the profits).
Even if you believe Google profits will go up and up for forever, the lack of dividends means the shareholders will never get to see any of those profits. So why does anyone buy the stock?

2

We have done this one a bunch of times. I have thought of it myself and don’t disagree with you all that much. In a way it is like a pyramid scheme where private investors trade virtual stock certificates around by themselves hoping to increase the value each time around and then not get burned if it crashes.

Others will counter that companies buy back their stock all the time so stocks are always tied to the company. Companies can also be sold and stock holders are entitled to their peice of the purchase price when that happens. I recently had a suprise when some stock that was given to me when I was born turned out to be worth something when the company got sold 33 years later. They made extraodinary efforts to find me and make sure I got my (small) piece of the pie.

3

The stock market was originally founded to provide capital so the company could take that money and make the business grow. However it didn’t take people long to figure out how to turn it into a “legalized” form of gambling. Now some people still invest to help the company grow, but few people feel that they are in somehow “owners” of the company. They feel they are in it to make money.

Further complicating the issue is in the past most companies in the US produced something tangible.

For instance US Steel made well, steel. Even if the market collapsed in the end you still had a tangible product. This made it easier to determain a company’s bottom worth.

For instance if Ford Auto makes cars and can’t sell them, in the end you still have a bunch of cars worth a few cents for their parts and recyling value, but in the 80s the US shifted to a service economy. This made it harder to judge

Look at Google? What is that? It’s an idea? It has nothing tangible. This is why it goes around buying things. You can’t really put a price on an idea which is how to get quality results out of a search engine. As soon (if this ever happens) as someone comes up with a better search engine, Google (like Alta Vista) may fade away, and unlike the Ford Auto, if it goes belly up there isn’t even left over cars with a few cents for parts and recycle value.

4

The market has changed considerably since the days when people were advised to buy stock in a corporation and just hold onto it until retirement. Focuses are very short-term. The price of the stock itself is the major concern, so people buy and hold stocks for only short periods of times, hoping for a quick score. Profits have little or nothing to do with it. It is the future value of the stock that people are betting on when they price a share, and that future future is built in immediately as soon as the information comes out. Those who can exploit the information first make the most. Therefore firms with no profits or even large losses can see rises in the price per share. People who disagree can sell short and make money if their bet is right.

Yes, this certainly has what appear to be a number of ill-effects on the companies involved. There’s no question that CEO’s - who also will be with the company for a very short period of time and whose compensation packages rely on stock price increases - have every incentive to push the price higher in the short term regardless of what it does to the long-term prospects of the company. The Internet bubble also saw day traders who took extremely short term positions on stocks hoping to make money on tiny fluctuations. (Of course, you don’t see that as much in a more slowly-growing market like today’s. They’ve been replaced by instituional investors using computer models and computer selling.)

Neither effect is remotely similar to the Good Old Days. Stock price, not dividends, is the new reality. People have adapted to the new environment. And those that haven’t adapted have often lost. Darwin in action.

5

The vast majority of outstanding shares in USA stocks aren’t held by short term traders, nor even by individual stock holders, but rather by huge companies that offer them as investment vehicles, such as mutual funds. The prospectuses of virtually any fund won’t mention day trading.

6

A few points:

Most dividend-paying stocks do not pay a high enough dividend to really make them an attractive investment for the dividend alone. As of last Friday: MMM - 2.2% yield, JNJ - 2.6%, KO - 2.6%, IBM - 1.5%, CAT - 1.5%, XOM 1.7% … I’m deliberately choosing very mature blue chips here. There are some exceptions, and certain industries like banking and big pharma tend to run towards higher dividends. But most really high yield things you find trading on the NYSE won’t be actual companies. They’ll be closed end income funds, REITs, BDCs, royalty trusts, MLPs, etc. These are different sorts of investments, which should should not be judged using the same metrics as normal companies.

Why is the dividend attractive, then? Some people would say it isn’t. Others might tout “dividend growth” - a company which is committed to increasing its dividend will also generally see the stock price increase over the long haul. JNJ is a quintessential example - they’ve increased their dividend yearly for a LONG time. The dividend yield has never been very high, but if you had bought them in 1990 for about $7 (split adjusted - there’s been 3 splits since then), the current dividend would be about a 23% yield against your original investment, which would have increased about 9-fold in value. Without reinvesting the dividends. Most of the “dividend growth” proponents will make it look even better by telling you want would have happened if you had reinvested.

Why do people not want the company to pay a dividend, then? Well, if you trust the management of the company to do something useful with the profits and accumulated cash which will increase the earnings, this will presumably increase the valuation of the company, as reflected in the share price. You might prefer that they go ahead and do that, rather than giving you some of the profits. For one thing, the dividend payout is income, and it will be taxed (although “qualified” dividends have gotten a reduced rate for the last few years). If your shares increase in value, you don’t incur tax until you sell, and if you held for over a year, that’s long term capital gains - lower tax.

Another thing the company with cash might do instead of handing out dividends is initiate a buyback - there’s been a bunch of buyback announcements recently. By buying back shares and retiring them, the company again presumably increases the value of your shares by reducing the number of slices the pie is cut into. And again, you don’t pay tax on the increased value. As a shareholder, you may like the company to do this, also.

Don’t bet that GOOG will NEVER pay dividends. It might just take a while. You probably would have said the same thing about Microsoft several years ago. MSFT now sports a 1.3% dividend yield.

7

You misunderstand the meaning of short-term if you think this.

Mutual funds are institutional traders. So are pension funds, hedge funds, and the thousand-and-one other ways of collecting large sums of money and using that economic leverage. All of them constantly readjust their portfolios, moving in and out of sectors and of individual stocks.* The amount of time spent in any individual stock varies but I doubt if this year’s portfolios bear any resemblance to those of 5, 4, 3, or 2 years ago. That’s short-term.

I said specifically that you don’t see as much day trading any more. It’s no longer a profession for individuals. But the equivalent occurs in the computer trading of vast institutional funds. Why else would there be several percentage point changes in stocks when earnings are announced or other news generated, and then corrections over the next few days? Nobody calls this day trading, but it amounts to the same thing.

Stocks used to be held for years. Now the focus is quarter-by-quarter. That’s a fundamental shift from long-term to short-term, no matter what name it’s called.

Stocks are future valued. Venture capitalists can afford to wait for returns on their money, but the annual yield of a mutual fund or other investment is what brings in the money. And they move the money around to make it happen.

*Investment portfolios also move in and out of real estates, bonds, commodities, futures, derivatives, and the other ways of investing money other than the stock market and do so in response to short-term fluctuations in the yields of these various sectors.

8

This is basically the reason I was going to give – to control taxes.

E.g., I retire in nine years. Right now, I’m working, so my tax rate is relatively high and I don’t need income.

So it behooves me to invest in stocks that will grow my savings (i.e., increase in value) rather than pay dividends, to the extent that there’s a tradeoff.

When I retire, my income will decrease. I will need income and my marginal tax rate will go down, so dividend-paying stocks will more attractive to me.

9

One often repeated claim by the executives of companies that don’t pay dividends is that the stock value will increase more when the money is reinvested in the company that you could earn on the dividends paid to you.

10

The answers can be several:

It can be a “growth stock” – the company is profitable, but instead of paying out profits as dividend, reinvests them to expand, refurbish, and/or restock to assure its continued and growing profitability. If I distribute $2 million profit to the shareholders of a million shares, each share earns $2 dividend. But if I take that $2 million and open up four more half-million-dollar-cost outlets to add to my present 12, I now have 16 outlets bringing in more profits next year, with the equivalent profit next year being $2.6 million ceteris paribus.

It can be a sure, stable investment, a company content with a low-risk, low-profit scenario that is guaranteed to keep its value stable. If we can assure a stable customer base by selling a particular high-ticket item which is purchased every few years at a few hundred over cost, underselling the competition, we don’t make a lot of money but we guarantee a stable business no matter which way the economy jinks.

It can be a gamble – a company which is a very high-risk investment for potentially very high return, and which devotes what income it has to continuing the high-risk high-potential scenario. If the company is an exploratory resources company (oil/gas, precious metals, nonferrous metals, whatever), it is gambling that it can secure mining rights to at least one highly profitable deposit, by buying up a bunch of rights to good-prospect sites, expecting that at least a few of them will fall through. It makes its money by “striking it rich” once amidst several worthless or barely-break-even site explorations. And it may well pour that money back into buying rights for good-prospect sites, in an effort to hit several more lucrative sites.

11

Another oft-repeated point is that dividends are “double taxed” - the company payed tax on earnings, then the shareholder pays tax on the dividend income. This is what the qualified dividend change was intended to address, to some degree, by allowing the shareholder to pay a lower tax rate on them.

BTW, there are countries, like Brazil, that require profitable companies to pay dividends. At least 25% of their net income, IIRC. Their dividend yields can be rather irregular, depending on how good a year the company had.

12

But you could ALWAYS make that argument about almost any company, so by that logic, a company will never pay dividends.
I understand why investors might buy a growth stock that doesn’t pay dividends, if reinvesting the profits means they’ll eventually get paid an even bigger dividend years later. But look at Microsoft – it took 21 years after the IPO before they started paying out (and even then, the divident was relatively small). Seems an awful long time for early investors to wait. Unless the whole thing really is just a pyramid scheme where the stock keeps going up but the last person to buy has no way to cash out…

13

Dividends are only one way to make money off a stock, and they are not a very important way. There are very few stocks that pay dividends high enough to make them an attractive investment on that basis alone.

People buy stocks because the company’s value is reflected in the stock price. The value of a company is not fixed. It can go way up or it can go to zero. The company’s value can grow by increasing production, buying other firms, becoming more efficient, or other means. If it does, that value should be reflected in the stock’s price, no matter what the current profits of the company are. Many companies, in fact, go deeply into debt to purchase other companies but still have their stock go up. Why? Because the total value of the company is higher, and if the company should be purchased by someone even larger, that value will be reflected in the price tendered for the stocks.

This is not in any way a pyramid scheme. Although the worth of some of these moves is certainly debatable as good long-term corporate strategies, intelligent investors know exactly what they are paying for. Early investors in Microsoft were more than repaid by the increase in value of their stock despite the lack of dividends. That’s because the value of Microsoft as a company also increased. It’s true that the last several years has not shown this increase in stock price, even though dividends started being paid. Investors over these years either made foolish decisions about their investments or else were looking far ahead and may yet make money on the stock price or else sold their stock for small increases and moved on to other investments (or sold for small decreases and moved on to other investments).

In every case, dividends were irrelevant. Dividends are almost always irrelevant. Almost any other form of investment will bring a better return than stock dividends. They’re a nice little extra, especially if you reinvest them in the stock itself, but that’s about all.

Could you explain why you think dividends are so important? Or why you think investors in stocks should pay attention to them?

14

I bought Google at 175 and sold it, (at the right time for once) at 500. Nuff said. And my money market fund statement is my cite. :slight_smile:

Actually, as I approach retirement, I am moving more of my money into reasonably steady dividend paying investments. There are some stocks out there which are still fairly stable - clearly not in high tech. So there are dividend paying stocks out there, but it makes a lot more sense to own them at 60 than it does at 30.

15

Two words: “Capital Gains”.

16

Well yes, clearly you’re right – lots of people buy stocks without considering dividends. But WHY? Suppose I write “Google Stock” on a piece of paper and offer to sell it to you, claiming this piece of paper will rise & fall with Google’s profits. You reply, “Nonsense, there’s no connection whatsoever between your piece of paper and Google’s profits”. But I counter, “Well, what exactly is the connection between the real Google stock and Google’s profits?”

If Google starts paying dividends, then there’s a connection between the stock and the profits, because the stock entitles you to a share of those profits. But otherwise, what’s the connection? The stock might tank even though the company is doing very well (or vice versa). So if you’re not getting a share of the profits through dividends, the only way to make money is to sell the stock to someone else at a higher price. But the guy who buys it won’t be able to get a share of the profits either, so why does he even care what the profits are? Without dividends, what keeps the stock price connected to the fate of the company?

17

Some reasons to own stock that aren’t based on dividends:

[ul]
[li]Of course, to buy low and sell high based on other people’s predictions of how well the company will do. I’m sure you understand this, even though it is irrational of these investors.[/li][li]When the economy is doing well, people will have more money available and they will invest more of it in stocks to keep it secure. Thus, one can say generally that the stock market will rise when the economy does well, and buying and selling stocks can be a way of gambling on how well the economy will do generally, which can be tied to all sorts of fun stuff like the likelihood of war. In a sense, it’s a way of gambling on world events.[/li][li]Stocks can be a safe-haven from taxation, making them a reliable place to store wealth.[/li][li]Owning stock indicates a degree of power in being able to control a company. Bigger profits indicate more control. If I get enough stock of a company, after all, I own it, and shareholders can vote on small decisions. I might want to own dividend-less stock simply because I derive satisfaction out of this power.[/li][li]Some day, the company might set up a dividend. High profits show that the dividend will be high. This is well documented above.[/li][/ul]

Buying low and selling high is obviously the primary reason to own stock. I think the root of your question is why stock prices increase when a company is doing well. I think there are several reasons for this.
[ul]
[li]Other people are irrational and believe in a connection between profits and stock price, so that investors can count on this belief and use stocks as an elaborate gambling system. I’m sure you get this one, unsatisfying as it may be.[/li][li]Profits indicate that the company in question is unlikely to go bankrupt any time soon, so that investors will prefer it as a safer place to store money.[/li][li]Since the leadership of a company almost always has a large amount of stock in the company they run, it is safe to assume that they will try everything in their power to raise to stock price. If a company is profitable, it shows that they are successful, which shows that they will likely be successful in raising the stock price as well through other methods.[/li][/ul]

Hopefully this answers your question. I’ve wondered the same thing myself, and the short answer is that it’s a house of cards, just as you suspect.

18

False. Owning stock is a stake in the assets of a company after liabilities are settled. So, if I own 10% of Google stock, I own 10% of their patents, servers, office chairs and sodas in the vending machine. If Google grows (capital appreciation) they will have more assets than when I bought them, making my pie slice bigger. A piece of paper in your example conveys no such ownership.

I think the misunderstanding here arises because most people don’t think of a share of stock as owning .00000001% (or whatever) of the company.

19

Suppose someone owns a grocery store and sells half the business to a partner at a negotiated price. The price would depend on the store’s assets, liabilities, history of profits, etc., and would be half the value of the store as a whole. The new co-owner would then share in the assets, liabilities, profits, etc. The new co-owner could later sell his half of the business. At the point he does so, the business might be worth more (or less) than when he originally bought his half, and the price of his share of the grocery store would change accordingly. The assets to be taken into account would include cash, cans of beans, refrigeration equipment, etc. If the store made money and the owners invested it in the business in an intelligent way, the selling price of the store could go up. For example, if the owners used cash to buy new cash registers, the value of those registers would be used to figure the price of either owner’s half of the company should he decide to sell.

Now, the owners could decide to simply divide up the profits between themselves, in which case their personal bank accounts would increase but the assets of the store wouldn’t. Consider how this decision - whether to take profits or reinvest them - would affect the selling price for either business owner. In one case he could say, “I haven’t personally made much money off this store, but look at the value of the assets.” In the other case he could say, “The store’s assets may not be great, but look at the profits it delivers.”

This is pretty much how stock works - shareholders in a company’s stock own part of the company. The company can invest its profits or distribute them as dividends. If it invests its profits intelligently the company’s assets increase, which drives the stock price up. If it distributes dividends the company’s assets may not increase as much, but it can point to a history of delivering cash to its investors.

20

I think this question is at the heart of the matter:

If a company is known to have never paid dividends, and is not likely to pay dividends soon, why does the value of the stock rise in the first place?

If the point of buying a dividend-less stock is that you can sell it to someone else for higher, why is that higher-paying buyer even out there, if they too know they won’t get a dime of the company’s profits?

If the only reason the higher-paying buyer is out there is that they hope to turn it around into a higher profit upon sale of the stock, then it all does resemble a pyramid scheme.