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Consider two companies, A and B. Company A offers little in dividends, and reinvests most its profit. Company B offers generous dividends, but reinvests little of its profit. How would I calculate which company is best to invest in? Given a specified time frame, I will sell all my shares and add the profit to whatever dividends I have received over that time.

My intuition is that a company that reinvests its profits will grow quicker, and therefore its share price will rise faster, so this might be a good bet for the long term. However, a company that offers generous dividends will return more in the short term. Plus, of course, it offers some security in a steady stream of income.

What's the best way of approaching this? Is it a long-term vs short-term decision, or more complex than that?

  • Are the dividends being used to buy more shares in both cases? – JB King Aug 20 '15 at 15:17
  • Not in my original idea, I would just keep the dividends as cash. I suppose if I were to reinvest them then it becomes even more complex... – Karnivaurus Aug 20 '15 at 15:24
  • Your intuition is wrong long term dividends when reinvested are a major part of the return on stocks and shares – Pepone Aug 23 '15 at 15:42
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It is a bit more complicated than whether it pays more or less dividends. You should make your decision based on how well the company is performing both fundamentally and technically.

Concentrating mainly on the fundamental performance for this question, most good and healthy companies make enough profits to both pay out dividends and invest back into the company to keep growing the company and profits. In fact a good indication of a well performing company is when their dividend per share and earnings per share are both growing each year and the dividends per share are less than the earnings per share (that way you know dividends are being paid out from new profits and not existing cash holdings). This information can give you an indication of both a stable and growing company.

I would rather invest in a company that pays little or no dividends but is increasing profits and growing year after year than a company that pays higher dividends but its profits are decreasing year after year. How long will the company continue to pay dividends for, if it starts making less and less profits to pay them with? You should never invest in a company solely because they pay dividends, if you do you will end up losing money. It is no use making $1 in dividends if you lose $2+ because the share price drops.

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 for a stable and growing company.

  • No stable company grows at 100% a year – Pepone Aug 23 '15 at 15:43
  • Actually, Victor knows his stuff. A company has to start somewhere, and while it may seem a given, sales in the early years may need to double annually, and the company value along with it. Of course, it will reach a level where the growth gets a bit more realistic, the 50-100% doesn't last forever. – JoeTaxpayer Aug 23 '15 at 21:34
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    @Pepone - I was talking about the capital gains from the share price increasing not the actual growth of the company, but as Joe has mentioned they can grow quite rapidly early on. – Victor Aug 24 '15 at 10:14
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Let's say two companies make 5% profit every year. Company A pays 5% dividend every year, but company B pays no dividend but grows its business by 5%. (And both spend the money needed to keep the business up-to-date, that's before profits are calculated).

You are right that with company B, the company will grow. So if you had $1000 shares in each company, after 20 years company A has given you $1000 in dividends and is worth $1000, while company B has given you no dividends, but is worth a lot more than $2000, $2653 if my calculation is right. Which looks a lot better than company A.

However, company A has paid $50 every year, and if you put that money into a savings account giving 5% interest, you would make exactly the same money either way.

  • So how do you know that $1000 worth of company B today will be worth $2653 in 20 years time. And how do you know company A will still only be worth $1000 in 20 years time? Have you got a crystal ball? Can I borrow it? – user9722 Jan 10 '16 at 13:44
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Someone (I forget who) did a study on classifying total return by the dividend profiles. In descending order by category, the results were as follows:

1) Growing dividends. These tend to be moderate yielders, say 2%-3% a year in today's markets. Because their dividends are starting from a low level, the growth of dividends is much higher than stocks in the next category.

2) "Flat" dividends. These tend to be higher yielders, 5% and up, but growing not at all, like interest on bonds, or very slowly (less than 2%-3% a year).

3) No dividends. A "neutral" posture.

4) Dividend cutters. Just "bad news."

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