Ask Money

The value in stocks

Chris Farrell Nov 10, 2011

Question: I have a question that’s more philosophical than practical, but it’s something I’ve never received a satisfactory answer to. Assuming they don’t pay dividends (which plenty of stocks don’t), why do people buy stocks from other people? I get that if I buy a stock for $20, I can later sell it to you for $30. But why are you or anyone willing to pay more for it other than to sell it later? If a stock doesn’t pay dividends, why is someone willing to buy it at all? Jake, Madison, WI

Answer: It’s a good question and a very practical one. As you can probably imagine there are all kinds of twists and nuance to answering your question. I’m going to try and boil it down to the essentials.

When a company has earnings management can choose to pass along some of that income directly to its owners through dividend payments or it can retain control of the earnings and reinvest the money in the business. Shareholders in dividend paying stocks typically get the bulk of their return from those payments. Shareholders in companies that don’t pay a dividend get their gains from the growth and appreciation of the underlying business–buying low and selling high.

Historically, dividend payments were critical for convincing investors to put bets on risky stocks. Dividends are a way of giving shareholders power over some of a company’s earnings since they can choose to reinvest it in the company, buy a different stock or asset, or spend it at the mall. Dividend paying companies typically have a slow growth outlook and lots of cash, such as utilities and banks.

Dividend paying stocks tend to be “value” stocks, too.

Management can elect to keep any earnings and reinvest it in the business. It increases the power of management over shareholders. It has become a more popular approach in recent decades with the healthy growth in corporate profits and a strong underlying economy (that is, until recently). Many industries enjoyed rapid growth, such as information technology and biotech companies.

Fast-growing companies don’t pay dividends because they need all their cash to fund their expansion. Shareholders pocket their profit when they sell the stock at a higher price than they bought it. The sale goes to someone who remains optimistic about the company’s growth prospects compared to the more pessimistic seller. To use your example, they’ll buy it from you at $30 a share because they think it will be worth more than that in the future.

These tend to be so-called “growth” stocks.

Now, dividend payments have become increasingly popular with investors in recent years. One reason is accounting fraud. The notion–and I think the insight is right–is that it’s harder to cook the books if management is actually paying out cash dividends to shareholders. Another factor is shareholders are rewarding companies that pay a good dividend in today’s low interest rate environment. Many large companies with flush balance sheets are hiking their dividend payments to hold on to individual investors, who tend to be more loyal than hedge funds and other Wall Street gunslingers.

That said, U.S. investors still like to plunk down big bets on companies with a strong earnings outlook–and no dividends.

As I said, there is more to this story. Does anyone else want to weigh in?

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