Why should I ever buy stock in a company that issues no dividends?
Imagine there’s a market of shallow pocketed investors (so no one has enough to buy a controlling interest in a firm) and that there are two identical companies with the same financial characteristics and same expected future business activity.
There is one major difference, Company A issues an annual dividend, while Company B never will (say they reinvest earnings in an index fund that just so happens to return the cost of equity). There are no taxes on dividends and there are no external investment opportunities that exceed the cost of equity.
Should the companies trade at the same price? Should you as an individual investor ever buy stock in company B?
....
Below are the motivations for this hypothetical:
It seems like we as investors try and use bond math to value equities, but should we be valuing a company on cash flows which we personally shall never receive? (This is not the case with bonds, at least as I understand it.)
The only cash flow you receive from B is the sale of stock. Presumably someone who is willing to buy that share from you took the pv of all future cashflows to equity and divided by the number of shares to arrive at their willingness to pay. But does that really make sense if those cash flows never actually flow to the investor himself as they would with a bond?
It seems like you only buy stock in B if you trust that everyone always and forever will value B’s stock using that formula.
Please point out any flaws in this line of reasoning, odds are the market is rational and I am misunderstanding something. Just trying to learn!
Rational investors (who do not own controlling interests independently) could at any time force management to return cash flow to equity holders through a proxy vote, combining the power of their individual votes together. Given that Company A and B both return the cost of equity and have no debt, there is a 0 net present value in the incremental cash flows of one company over another, so they should be worth the same.
Does this imply that, in theory, every company which does not currently pay a dividend is expected to eventually pay one out as soon as a critical mass of rational investors start to believe it's a good idea?
If that's the case, wouldn't there be a discrepancy in valuation due to the fact that cash flows via dividends would accrue to investors of the currently non-dividend company at some unknown point in the future (therefore offering less upside over a discrete time horizon compared to a company paying dividends in the status quo)?
You could probably argue that there should be a "uncertainty of realization of gains" risk premium, which would result in the equity of B trading at a discount to the FCFF. However this can essentially be "arbitraged out" (no clue if this is the correct term) by other investors who are willing to hold the company indefinitely (or until a proxy vote), who will then realize gains (alpha) above the cost of equity. I would expect this to be "arbitraged out" to 0 risk premium, as in a liquid market, if one investor is no longer able to hold the equity until gains are realized, a rational investor should snap up those shares at discount and proceed to "take over" the position of the first investor. I have no idea if any of that makes sense/is correct, however this seems to me to be the most rational outcome given the assumptions.
This type of interview question is classic and tries to make sure you understand what a DCF valuation methodology is actually doing, especially when unlevered FCF is used for explicit dividends - the answer is no difference in value between companies. But here are some nuances in reality:
If Company A is dividending out part of its retained earnings (therefore reducing invested capital) each year while still being able to make the same financial metrics that is a superior ROIC. But I think you mean earns the same proportions of metrics and therefore just same ROIC on the reduced capital base. Are Company B’s reinvestments growth oriented or actually required (more like working capital) to maintain market share, competitive position, etc.? Also worth considering more deeply.
Finally, think about each Company as the sum of Management Team + Business. Reasons why B is worth more / less are related to management team being more growth-oriented / capital return oriented.
1) if a stock will never pay dividends, it is worthless. No such stock exists because shareholders will only allow companies to retain earnings if it can be reinvested at a superior rate.
2) as active investors we intend to beat the index. So having the company returning the earnings to the shareholders through buybacks and dividends is much better than keeping the earnings in an index fund, which dilutes alpha.
Corporate CEOs are above all allocators of capital. If they can reinvest profits at a high rate of return, you want them to keep all those profits and reinvest them, rather than pay them back as dividends. This is the definition of "compounder" companies that everyone tries hard to identify.
No one buys Berkshire Hathaway to get paid a dividend. Same logic applies to a ton of companies with smart management teams that can find good investment opportunities.
And that's before considering the massive hit that you take having to pay taxes on dividends.
In the simplified example you would be indifferent then no? We don't need any outperforming capital allocators as the only options are to hold Stock A, hold Stock B or invest in an index that just so happens to be returning the cost of equity of either business. There are no outsized investment opportunities.
The only difference is do you want dividend in cash, which you then use to go and buy the index (company A). Or do you want the company to reinvest earnings into the index? Having the option to consume that cash with company A seems nice to me as an individual investor maybe it should trade at a slight premium?
Laboriosam et reiciendis omnis et. Fuga quam qui voluptate aperiam. Eum eos voluptatum voluptatem architecto. Minus iusto distinctio iure error sit expedita quibusdam.
Quo in fuga non ut. Facere maiores nihil reiciendis saepe doloribus quos. Veniam ut occaecati at consequuntur.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...