I read somewhere that companies are not required to pay dividends to shareholders (this is correct, yes?).
If so, then if company A never pays dividends to its shareholders, then what is the point of owning company A's stock? Surely the right to one vote for company A's Board can't be that valuable.
What is it that I'm missing?
It's important to remember what a share is. It's a tiny portion of ownership of a company.
Let's pretend we're talking about shares in a manufacturing company. The company has one million shares on its register. You own one thousand of them. That means that you own 1/1000th of the company.
These shares are valued by the market at $10 per share. The company has machinery and land worth $1M. That means that for every dollar of the company you own, 10c of that value is backed by the physical assets of the company. If the company closed shop tomorrow, you could, in theory at least, get $1 back per share. The other $9 of the share value is value based on speculation about the future and current ability of the company to grow and earn income.
The company is using its $1M in assets and land to produce goods which cost the company $1M in ongoing costs (wages, marketing, raw cost of goods etc...) to produce and make $2M per year in sales. That means the company is making a profit of $1M per annum (let's assume for the sake of simplicity that this profit is after tax).
Now what can the company do with its $1M profit? It can hand it out to the owners of the company (which means you would get a $1 dividend each year for each share that you own (since the company would be distributing that $1M between each of its 1M shares)) or it can re-invest that money into additional equipment, product lines or something which will grow the business. The dividend would be nice, but if the owners bought $500k worth of new machinery and land and spent another $500k on ongoing costs and next year we would end up with a profit of $1.5M.
So in ten years time, if the company paid out everything in dividends, you would have doubled your money, but they would have machines which are ten years older and would not have grown in value for that entire time. However, if they reinvested their profits, the compounding growth will have resulted in a company many times larger than it started.
Eventually in practice there is a limit to the growth of most companies and it is at this limit where dividends should be being paid out. But in most cases you don't want a company to pay a dividend. Remember that dividends are taxed, meaning that the government eats into your profits today instead of in the distant future where your money will have grown much higher.
Dividends are bad for long term growth, despite the rather nice feeling they give when they hit your bank account (this is a simplification but is generally true).
TL;DR - A company that holds and reinvests its profits can become larger and grow faster making more profit in the future to eventually pay out. Do you want a $1 dividend every year for the next 10 years or do you want a $10 dividend in 5 years time instead?
Stephen's answer is the 100% correct one made with the common Economics assumption, that people are rational.
A company that never has paid dividends, is still worth something to people because of its potential to start paying dividends later and it is often better to grow now and payoff later.
However, the actual answer is much more disapointing, because people are not rational and the stock market is no longer about investing in companies or earning dividends.
Most of the value of a stock is for the same reason that gold, stamps, coins and bitcoins, and Australian houses are worth anything, that is, because enough people say it is worth something*.
Even stocks that pay dividends, very few people buy it for dividends. They buy it because they believe someone else will be willing to buy it for slightly more, shortly after. Different traders have different timeframes, ranging from seconds to months.
*Houses and stock are of course partially valuable due to the fundamentals, but the major reason they are purchased is just to resell at a profit.
This is an excellent question, one that I've pondered before as well. Here's how I've reconciled it in my mind.
Why should we agree that a stock is worth anything? After all, if I purchase a share of said company, I own some small percentage of all of its assets, like land, capital equipment, accounts receivable, cash and securities holdings, etc., as others have pointed out. Notionally, that seems like it should be "worth" something.
However, that doesn't give me the right to lay claim to them at will, as I'm just a (very small) minority shareholder. The old adage says that "something is only worth what someone is willing to pay you for it." That share of stock doesn't actually give me any liquid control over the company's assets, so why should someone else be willing to pay me something for it?
As you noted, one reason why a stock might be attractive to someone else is as a (potentially tax-advantaged) revenue stream via dividends. Especially in this low-interest-rate environment, this might well exceed that which I might obtain in the bond market. The payment of income to the investor is one way that a stock might have some "inherent value" that is attractive to investors.
As you asked, though, what if the stock doesn't pay dividends? As a small shareholder, what's in it for me? Without any dividend payments, there's no regular method of receiving my invested capital back, so why should I, or anyone else, be willing to purchase the stock to begin with? I can think of a couple reasons:
Expectation of a future dividend. You may believe that at some point in the future, the company will begin to pay a dividend to investors. Dividends are paid as a percentage of a company's total profits, so it may make sense to purchase the stock now, while there is no dividend, banking on growth during the no-dividend period that will result in even higher capital returns later. This kind of skirts your question: a non-dividend-paying stock might be worth something because it might turn into a dividend-paying stock in the future.
Expectation of a future acquisition. This addresses the original premise of my argument above. If I can't, as a small shareholder, directly access the assets of the company, why should I attribute any value to that small piece of ownership? Because some other entity might be willing to pay me for it in the future. In the event of an acquisition, I will receive either cash or another company's shares in compensation, which often results in a capital gain for me as a shareholder.
If I obtain a capital gain via cash as part of the deal, then this proves my point: the original, non-dividend-paying stock was worth something because some other entity decided to acquire the company, paying me more cash than I paid for my shares. They are willing to pay this price for the company because they can then reap its profits in the future.
If I obtain a capital gain via stock in as part of the deal, then the process restarts in some sense. Maybe the new stock pays dividends. Otherwise, perhaps the new company will do something to make its stock worth more in the future, based on the same future expectations.
The fact that ownership in a stock can hold such positive future expectations makes them "worth something" at any given time; if you purchase a stock and then want to sell it later, someone else is willing to purchase it from you so they can obtain the right to experience a positive capital return in the future. While stock valuation schemes will vary, both dividends and acquisition prices are related to a company's profits:
This provides a connection between a company's profitability, expectations of future growth, and its stock price today, whether it currently pays dividends or not.
It seems to me that your main question here is about why a stock is worth anything at all, why it has any intrinsic value, and that the only way you could imagine a stock having value is if it pays a dividend, as though that's what you're buying in that case.
Others have answered why a company may or may not pay a dividend, but I think glossed over the central question.
A stock has value because it is ownership of a piece of the company. The company itself has value, in the form of:
You get the idea. A company's value is based on things it owns or things that can be monetized.
By extension, a share is a piece of all that.
Some of these things don't have clear cut values, and this can result in differing opinions on what a company is worth.
Share price also varies for many other reasons that are covered by other answers, but there is (almost) always some intrinsic value to a stock because part of its value represents real assets.
If someone wants to buy the whole company, they can't do so without paying you for your share. might be the most straightforward answer I've seen across this and the several related questions I browsed this morning. I recall that one of them had a bit of a "circular logic" debate, and I think that can be resolved with "the person who buys your share for more than you paid is speculating that either 1) there'll eventually be dividends, 2) there'll eventually be a buyout/hostile takeover/share repurchase, or 3) I'll sell the share for even more, before 1) or 2) happens.
Commented
Aug 17, 2015 at 18:17
If so, then if company A never pays dividends to its shareholders, then what is the point of owning company A's stock?
The stock itself can go up in price. This is not necessarily pure speculation either, the company could just reinvest the profits and grow. Since you own part of a company, your share would also increase in value.
The company could also decide to start paying dividend. I think one rule of thumb is that growing companies won't pay out, since they reinvest all profit to grow even more, but very large companies like McDonalds or Microsoft who don't really have much room left to grow will pay dividends more.
Surely the right to one vote for company A's Board can't be that valuable.
Actually, Google for instance neither pays dividend nor do you get to vote. Basically all you get for your money is partial ownership of the company. This still gives you the right to seize Google assets if you go bankrupt, if there's any asset left once the creditors are done (credit gets priority over equity).
What is it that I'm missing?
What you are missing is that the entire concept of the dividend is an illusion. There's little qualitative difference between a stock that pays dividend, and a stock that doesn't.
If you were going to buy the stock, then hold it forever and collect dividend, you could get the same thing with a dividend-less stock by simply waiting for it to gain say 5% value, then sell 4.76% of your stock and call the cash your dividend. "But wait," you say, "that's not the same - my net worth has decreased!" Guess what, stocks that do pay dividend usually do drop in value right after the pay out, and they drop by about the relative value of the dividend as well.
Likewise, you could take a stock that does pay dividend, and make it look exactly like a non-paying stock by simply taking every dividend you get and buying more of the same stock with it.
So from this simplistic point of view, it is irrelevant whether the stock itself pays dividend or not. There is always the same decision of whether to cut the goose or let it lay a few more eggs that every shareholder has to make it. Paying a dividend is essentially providing a different default choice, but makes little difference with regards to your choices.
There is however more to it than simple return on investment arithmetic: As I said, the alternative to paying dividend is reinvesting profits back into the enterprise. If the company decided to pay out dividend, that means they think all the best investing is done, and they don't really have a particularly good idea for what to do with the extra money. Conversely, not paying is like management telling the shareholders, "no we're not done, we're still building our business!". So it can be a way of judging whether the company is concentrating on generating profit or growing itself. Needless to say the, the market is wild and unpredictable and not everyone obeys such assumptions. Furthermore, as I said, you can effectively overrule the decision by increasing or decreasing your position, regardless of whether they have decided to pay dividend to begin with.
Lastly, there may be some subtle differences with regards to things like how the income is taxed and so on. These don't really have much to do with the market itself, but the bureaucracy tacked onto the market.
Imagine that a company never distributes any of its profits to its shareholders. The company might invest these profits in the business to grow future profits or it might just keep the money in the bank. Either way, the company is growing in value. But how does that help you as a small investor? If the share price never went up then the market value would become tiny compared to the actual value of the company. At some point another company would see this and put a bid in for the whole company. The shareholders wouldn't sell their shares if the bid didn't reflect the true value of the company. This would mean that your shares would suddenly become much more valuable.
So, the reason why the share price goes up over time is to represent the perceived value of the company. As this could be realised either by the distribution of dividends (or a return of capital) to shareholders, or by a bidder buying the whole company, the shares are actually worth something to someone in the market. So the share price will tend to track the value of the company even if dividends are never paid.
In the short term a share price reflects sentiment, but over the long term it will tend to track the value of the company as measured by its profitability.
I haven't seen any of the other answers address this point – shares are (a form of) ownership of a company and thus they are an entitlement to the proceeds of the company, including proceeds from liquidation.
Imagine an (extreme, contrived) example whereby you own shares in a company that is explicitly intended to only exist for a finite and definite period, say to serve as the producers of a one-time event. Consider a possible sequence of major events in this company's life:
So why would the shares of this hypothetical company be worth anything? Because the company itself is worth something, or rather the stuff that the company owns is worth something, even (or in my example, especially) in the event of its dissolution or liquidation.
Besides just the stuff that a company owns, why else would owning a portion of a company be a good idea, i.e. why would I pay for such a privilege?
Buying shares of a company is a good idea if you believe (and are correct) that a company will make larger profits or capture more value (e.g. buy and control more valuable stuff) than other people believe. If your beliefs don't significantly differ from others then (ideally) the price of the companies stock should reflect all of the future value that everyone expects it to have, tho that value is discounted based on time preference, i.e. how much more valuable a given amount of money or a given thing of value is today versus some time in the future. Some notes on time preference:
But apart from whether you should buy shares in a specific company, owning shares can still be valuable. Not only are shares a claim on a company's current assets (in the event of liquidation) but they are also claims on all future assets of the company. So if a company is growing then the value of shares now should reflect the (discounted) future value of the company, not just the value of its assets today.
If shares in a company pays dividends then the company gives you money for owning shares. You already understand why that's worth something. It's basically equivalent to an annuity, tho dividends are much more likely to stop or change whereas the whole point of an annuity is that it's a (sometimes) fixed amount paid at fixed intervals, i.e. reliable and dependable.
As CQM points out in their answer, part of the value of stock shares, to those that own them, and especially to those considering buying them, is the expectation or belief that they can sell those shares for a greater price than what they paid for them – irrespective of the 'true value' of the stock shares.
But even in a world where everyone (magically) had the same knowledge always, a significant component of a stock's value is independent of its value as a source of trading profit.
As Jesse Barnum points out in their answer, part of the value of stocks that don't pay dividends relative to stocks that do is due to the (potential) differences in tax liabilities incurred between dividends and long-term capital gains. This however, is not the primary source of value of a stock share.
While there are many very good and detailed answers to this question, there is one key term from finance that none of them used and that is Net Present Value.
While this is a term generally associate with debt and assets, it also can be applied to the valuation models of a company's share price.
The price of the share of a stock in a company represents the Net Present Value of all future cash flows of that company divided by the total number of shares outstanding. This is also the reason behind why the payment of dividends will cause the share price valuation to be less than its valuation if the company did not pay a dividend. That/those future outflows are factored into the NPV calculation, actually performed or implied, and results in a current valuation that is less than it would have been had that capital been retained.
Unlike with a fixed income security, or even a variable rate debenture, it is difficult to predict what the future cashflows of a company will be, and how investors chose to value things as intangible as brand recognition, market penetration, and executive competence are often far more subjective that using 10 year libor rates to plug into a present value calculation for a floating rate bond of similar tenor. Opinion enters into the calculus and this is why you end up having a greater degree of price variance than you see in the fixed income markets.
You have had situations where companies such as Amazon.com, Google, and Facebook had highly valued shares before they they ever posted a profit. That is because the analysis of the value of their intellectual properties or business models would, overtime provide a future value that was equivalent to their stock price at that time.
The answer is Discounted Cash Flows.
Companies that don't pay dividends are, ostensibly reinvesting their cash at returns higher than shareholders could obtain elsewhere. They are reinvesting in productive capacity with the aim of using this greater productive capacity to generate even more cash in the future.
This isn't just true for companies, but for almost any cash-generating project. With a project you can purchase some type of productive assets, you may perform some kind of transformation on the good (or not), with the intent of selling a product, service, or in fact the productive mechanism you have built, this productive mechanism is typically called a "company".
What is the value of such a productive mechanism? Yes, it's capacity to continue producing cash into the future.
Under literally any scenario, discounted cash flow is how cash flows at distinct intervals are valued. A company that does not pay dividends now is capable of paying them in the future. Berkshire Hathaway does not pay a dividend currently, but it's cash flows have been reinvested over the years such that it's current cash paying capacity has multiplied many thousands of times over the decades.
This is why companies that have never paid dividends trade at higher prices. Microsoft did not pay dividends for many years because the cash was better used developing the company to pay cash flows to investors in later years.
A companies value is the sum of it's risk adjusted cash flows in the future, even when it has never paid shareholders a dime.
If you had a piece of paper that obligated an entity (such as the government) to absolutely pay you $1,000 20 years from now, this $1,000 cash flows present value could be estimated using Discounted Cash Flow. It might be around $400, for example. But let's say you want to trade this promise to pay before the 20 years is up. Would it be worth anything? Of course it would. It would in fact typically go up in value (barring heavy inflation) until it was worth very close to $1,000 moments before it's value is redeemed.
Imagine that this "promise to pay" is much like a non-dividend paying stock. Throughout its life it has never paid anyone anything, but over the years it's value goes up. It is because the discounted cash flow of the $1,000 payout can be estimated at almost anytime prior to it's payout.
A stock that currently doesn't pay dividend can be worth a lot of money, because the stock will eventually pay dividend.
An example:
Let's consider you own a stock with market value that represents 0.01% of the total world economy.
The total world economy grows 5% nominally. Average stocks pay 3% dividend. However, this particular stock grows 8% nominally because it doesn't pay dividend and hence reinvests profits into growth.
In 312 years, the stock will represent 0.01% * 1.03^312 = 101.21% of the world economy. That's a mathematical impossibility. So, before 312 years have elapsed the stock will eventually have to start paying dividend. Otherwise it will run out of options to reinvest the profits.
Berkshire Hathaway is a very good example of a stock that doesn't pay dividend currently, but will eventually have to start paying dividend. Berkshire Hathaway, by the way, is 0.3% of the world economy (245.5 billion USD revenue, 80.934 trillion USD world GDP in 2017), so I make a prediction: before 197 years have elapsed, Berkshire Hathaway will have started to pay dividend.
Shareholders can [often] vote for management to pay dividends
Shareholders are sticking around if they feel the company will be more valuable in the future, and if the company is a target for being bought out.
Greater fool theory
Remember that long term appreciation has tax advantages over short-term dividends.
If you buy shares of a company, never earn any dividends, and then sell the stock for a profit in 20 years, you've essentially deferred all of the capital gains taxes (and thus your money has compounded faster) for a 20 year period. For this reason, I tend to favor non-dividend stocks, because I want to maximize my long-term gain.
Another example, in estate planning, is something called a step-up basis:
Not sure how this has got this far with no obvious discussion about the huge tax advantages of share buy backs vs dividend paying.
Companies face a very simple choice with excess capital - pay to shareholders in the form of a taxable dividend, invest in future growth where they expect to make more than $1 for every $1 invested, or buy back the equivalent amount of stock on the market, thus concentrating the value of each share the equivalent amount with no tax issues.
Of these, dividends are often by far the worst choice. Virtually all sane shareholders would just rather the company put the capital to work or concentrate the value of their shares by taking many off the market rather than paying a taxable dividend.
Stock has value to the buyer even if it does not currently pay dividends, since it is part ownership of the company (and the company's assets).
The owners (of which you are now a part) hire managers to make a "dividend policy decision." If the company can reinvest the profits into a project that would earn more than the "minimum acceptable rate of return," then they should do so.
If the company has no internal investment opportunities at or above this desired rate, then the company has an obligation to declare a dividend. Paying out a dividend returns this portion of profit to the owners, who can then invest their money elsewhere and earn more.
For example:
The stock market currently has, say, a 5% rate of return.
Company A has a $1M profit and can invest it in a project with an expected 10% rate of return, so they should do so.
Company B has a $1M profit, but their best internal project only has an expected 2% rate of return. It is in the owners' best interest to receive their portion of their company's profit as a dividend and re-invest it in other stocks.
(Others have pointed out the tax deferrment portion of dividend policy, so I skipped that)
Since I'm missing the shortest and simplest answer, I'll add it:
A car also doesn't offer dividends, yet it's still worth money.
A $100 bill doesn't offer dividends, yet people are willing to offer services, or goods, or other currencies, to own that $100 bill.
It's the same with a stock. If other people are willing to buy it off you for a price X, it's worth at least close to price X to you.
In theory the price X depends on the value of the assets of the company, including unknown values like expected future profits or losses. Speaking from experience as a trader, in practice it's very often really just price X because others pay price X.
The company gets it worth from how well it performs.
For example if you buy company A for $50 a share and it beats its expected earnings, its price will raise and lets say after a year or two it can be worth around $70 or maybe more.This is where you can sell it and make more money than dividends.
Stocks represent partial ownership of the company. So, if you owned 51% of the stock of the company (and therefore 51% of the company itself), you could decide to liquidate all the assets of the company, and you would be entitled to 51% of the proceeds from that sale.
In the example above, it would have to be Common Stock, as preferred stock does not confer ownership.
*In a situation where it is not possible to buy 51% or more of the company (for example, it's not for sale), this is not possible, so the value of the stock could be much less.
Most companies get taken over eventually. More to the point, ANY company with a public float over 50 percent that's large and viable enough to fall on people's radar screens will get taken over if its stock price is "too low" relative to its long term prospects.
It is the possibility of a takeover, as much as anything else, that bolsters the stock prices of many companies, particularly those that don't pay dividends. In essence, the takeover price is just one large liquidating "dividend."
You are missing the fact that the company can buy back its own shares.
For simplicity, imagine the case that you own ALL of the shares of XYZ corporation. XYZ is very profitable, and it makes $1M per year. There are two ways to return $1M to you, the shareholder:
1) The company could buy back some fraction of your shares for $1M, or
2) The company could pay you a $1M dividend.
After (1) you'd own ALL of the shares and have $1M.
After (2) you'd own ALL of the shares and have $1M.
After (1) the total number of shares would be fewer, but saying you owned less of XYZ would be like complaining that you are shorter when your height is measured in inches than in centimeters.
So indeed, a buyback is an alternative to a dividend.
Furthermore, buybacks have a number of tax advantages over dividends to taxable shareholders (see my answer in Can I get a dividend "free lunch" by buying a stock just before the ex-dividend date and selling it immediately after?). That said, it is important to recognize the shareholders who are less savvy about knowing when to accept the buyback (by correctly valuing the company) can get burned at the profit of the savvy shareholders. A strategy to avoid being burned if you aren't price savvy is simply to sell a fraction in order to get your pro rata share of the buyback, in many respects simulating a dividend but still reaping some (but not all) of the tax advantages of a buyback.
There are two ways that an asset can generate value. One is that the asset generates some revenue (e.g. you buy a house for $100,000 and rent it out for $1,000 per month) and the second way is that the asset appreciates (e.g you buy a house for $100,000, you don't rent it out and 5 years later you sell it for $200,000). Stocks are the same.
There are two main ways you can make money through shares: through dividends and through capital gains.
If the company is performing well and increasing profits year after year, its Net Worth will increase, and if the company continues to beat expectations, then over the long term the share price will follow and increase as well. On the other hand, if the company performs poorly, has a lot of debt and is losing money, it may well stop paying dividends. There will be more demand for stocks that perform well than those that perform badly, thus driving the share price of these stocks up even if they don't pay out dividends.
There are many market participants that will use different information to make their decisions to buy or sell a particular stock. Some will be long term buy and hold, others will be day traders, and there is everything in between. Some will use fundamentals to make their decisions, others will use charts and technicals, some will use a combination, and others will use completely different information and methods. These different market participants will create demand at various times, thus driving the share price of good companies up over time.
The annual returns from dividends are often between 1% and 6%, and, in some cases, up to 10%. However, annual returns from capital gains can be 20%, 50%, 100% or more. That is the main reason why people still buy stocks that pay no dividends. It is my reason for buying them too.
Securities change in prices. You can buy ten 10'000 share of a stock for $1 each one day on release and sell it for $40 each if you're lucky in the future for a gross profit of 40*10000 = 400'0000
