Why Buy Stocks (Especially Ones That Don’t Pay Dividends)?

I recently asked myself “Why do people by stocks”?  It seems like a simple question but I quickly hit a roadblock in my line of thinking.  By the way, when I say “people”, I literally mean everyone, including both large institutional investors and individual investors like you and me.

The content of this article may seem obvious to some but in speaking with a few others I realized that many people, including myself prior to this writing, don’t understand some fundamentals.

My Confusion

My line of thinking went like this: You buy shares in a company because you want a return on your investment (ie. to make more money).  The way in which you make money is either through sharing in the company’s profits (ie. a dividend or stock buyback) or through selling your shares at a higher price (capital gains).  But this latter method depends on the existence of people in the market willing to buy your shares at that higher price.  But why are they willing to do that? They have the same motivations as you.  They are expecting either a share of the company’s profits or, in turn, to sell at a higher price.  Again, this latter point depends on the existence of yet another person willing to buy at that even higher price.  But why is this third person willing to do that?  You can see how this continues in an infinite regression that seems kind of insane.  But I thought this was all fine and good as long as the company eventually shares its profits with the shareholders.  As the shares change hands, each owner is basically making a bet on how big their share of the profit will be (ie. betting on the company’s profitability) when it’s finally paid out.  But we all know many companies don’t directly share their profits with shareholders.  So why are people buying stocks in these companies?  What is their incentive?  Doesn’t this make the trading of these shares look like a Ponzi/pyramid scheme?  (I’m not saying that it’s a Ponzi scheme, just that the infinite regression qualities seem similar).

I tried researching this question and didn’t find much clear information online.  I also spoke with several people and nobody could give me a good explanation.  I realized that a lot of people, including myself, don’t fundamentally understand why a stock’s value fluctuates and why people invest in the first place.  It seems like a lot of people invest simply because they think the value will “go up” because of the company is “doing well” without really understanding what’s happening.  What enables the value to go up?  What does the share price even mean?  How do we clarify the confusion about the infinite regression?

The Basic Answer

The fundamental answer to all of this is that the profits must be shared with shareholders at some point.  This is what terminates the infinite regression.  If a company believes that they can retain their earned profits to further grow and generate even more profits, they will do so.  However if a company continues to grow and do well, eventually they will accumulate so much cash in the bank that they can’t find good use for all of it.  At this point they will have to pay it out to shareholders through a dividend or stock buyback.  If they refuse to, at some point the shareholders will band together and vote for new management that will pay it out.

In summary, the fundamental bet that is made by purchasing stock is that the company’s profits will eventually be paid out to shareholders.  It’s often true that your personal intention may be to sell before that happens and make a return on capital gains.  But the thing that enables you to do that — in other words, the thing that incentivizes the infinite regression of buyers is that eventually the profits will be shared.

Why Do Share Prices Fluctuate?

The share price on a given day is simply what people are willing to buy/sell it for on that day.  How do people decide what they are willing to pay?  A lot of complex analysis goes into this but it can all be summarized as basically trying to guess the company’s future profitability.  If people believe a company will be more profitable in the future and thus pay out more money to shareholders, the stock will be worth more.  In contrast if people believe the company will be less profitable, say because of some bad news or political uncertainty, the share price will decrease.  But as long as people believe some profits will be made the share price will stay above $0.  If everyone believes the company is going to dissolve, the share price will drop to $0 because what’s the point of investing if the company will never make any profits to share with shareholders?

Berkshire Hathaway

An interesting example is Warren Buffett’s company, Berkshire Hathaway, which is one of the most successful companies of all time.  Its book value has grown an average of almost 20% per year for the last 48 years and it has a market cap of $286B today.  At the end of 2012 Berkshire reported it had more than $40B cash in the bank and Retained Earnings of $124B, meaning that since the company’s inception it has re-invested $124B of the profits instead of paying them out [1].  Berkshire famously does not pay dividends despite having lots of cash in the bank.  Why?  Warren Buffett has continuously believed that he can get a positive return on every dollar he has in the bank, he has proven this year after year, and therefore says he will never pay a dividend [2].  This makes sense — he has shown he can get a 20% return on every dollar which is likely a lot better than what investors could otherwise get if they put the money elsewhere.  So why do people buy shares in Berkshire even though there will be no dividends in the foreseeable future?  The belief is that Berkshire’s ever-growing profits will eventually be distributed.  Nobody knows exactly when but it will happen when Berkshire is no longer able to successfully re-invest its profits.  If they don’t pay it out at this point, shareholders will vote to make it so.

I didn’t talk about acquisitions because they are just a special case of investing where you purchase 100% of the shares.  In an acquisition you are still motivated by the same things: you think the future profits justify the investment.

The only other article I found on this subject is [3].  It’s a good read and concludes the same thing: that the shareholders can vote to have dividends paid out.

If you have any feedback on what I’ve written please share it in the comments!

References

[1] http://www.berkshirehathaway.com/2012ar/2012ar.pdf, Page-30
[2] http://youtu.be/aL766NK2ynw?t=2m28s
[3] http://beginnersinvest.about.com/od/dividendsdrips1/a/why-stocks-without-dividends-can-still-be-a-good-investment.htm

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