What gives non-dividend stocks value to purchasers?

Question

This is a question that has bothered me for awhile about the fundmental nature of the stock market as a whole, and no one has given a satisfying explanation. What is root cause of a stock having value to purchasers if the stock doesn't pay dividends?

The obvious answer is that they can re-sell it to the someone and make a profit. However, that leads to the question as to why the next person feels it has value, other then to sell it to a third person etc etc. At some point some other source of income has to come from the constant selling/buying of the stock or else this is nothing more then a collectables bubble making Ameritrade rich on commisions. There must be some other intrinsic value to owning non-dividen stocks, but I'm not sure I fully understand the market forces involved.

To put things in an absurdly nerdy manner I feel as if I'm missing the base case in my inductive reasoning. If I'm trying to prove that person P should expect to profit from purchasing stock my inductive reasoning, projected backwards in time, would look like:

   Prove:  buyStock(p) = buyStock(P+1) + $ (my potential profits are > profit seller expects)

   because:
   Inductive: buyStock(P-1) = buyStock(P) + $ (someone in future will buy from me for a profit)
   base case: buyStock(0) = $$$ (person 0 profits ....somehow?)

In cases where companies pay dividens the base case is easy, person 0 gets a dividen as profit, proof done QED. But what about cases where a company is not currently paying dividens and is unlikely to do so?

I know that the stock price will go up as the company performs better, but I don't know why that is true either! If I own only 1% of the company I have no way of accessing the companies money, goods, or other resources. Rather the company is near bancruptcy or has trillions in their coffers does me no good because I can't access it in any way! I don't fully understand what market forces should cause my slip of paper to be worth more if the company I have no say, controll, or access to happens to do better. I'm sure if I knew my 'base case' I would be able to fully explain the correlation between company profit and stock price, and vic-versa, but simply knowing people will pay more for stock from a better performing company doesn't explain the intrinsic value.

So far I have two potential explanations to explaining my 'base case' as to the root advantage of trading stocks, but I don't feel either fully explains the advantage. The first is that companies often do stock buy-backs. This is definitely a source of profit for amateur traders, but I don't think this answers the question so much as makes it more indirect. The reason the company buys back it's stock is to 1) increase stock price and 2) have stock to sell back later. The company is not gaining immediate profit (I think) from the buyback, so they are not my base case in my inductive reasoning. The only reason the company seems to care about stock price is to resell later. In effect I could envision the company doing the buy-back as just another trader buying and selling stock (person p-1).

The other explanation, and so far the only one I like, is the risk of hostile take over. As long as there is a chance for someone to, one day, purchase 51% of the stock and now own the company this gives the stock value. Even if there is no reason for me to expect someone to try a hostile take over now, or close to now, there is still a chance that at some point eventually someone will be interested in doing so, and so everyone is really buying stock in the hopes of eventually selling it to someone who values it not for resell, but for a hostile takeover.

I like the above explanation, but it still fails to cover one use case. What about companies that only place 49% of their stock out there, while maintaining 51% for themselves. If these companies also refuse to pay dividends is there any incentive at all for anyone to buy this stock? how is the stock anything more then a sheet of paper?

So...can anyone explain market forces I'm missing? are there other advantages to holding of stock, or other means of making a profit from stocks, that make them ultimately worse constant trading? what forces stock price to have a correlation to company success rate?

Answer 1

Dividends are not fixed. A profitable company which is rapidly expanding, and thus cash-strapped may very well skip dividends, yet that same fast growth makes it valuable. When markets saturate, and expansion stops, the same company may now have a large free cash flow so it can pay dividends.

Answer 2

A share of stock is a share of the underlying business. If one believes the underlying business will grow in value, then one would expect the stock price to increase commensurately. Participants in the stock market, in theory, assign value based on some combination of factors like capital assets, cash on hand, revenue, cash flow, profits, dividends paid, and a bunch of other things, including "intangibles" like customer loyalty. A dividend stream may be more important to one investor than another. But, essentially, non-dividend paying companies (and, thus, their shares) are expected by their owners to become more valuable over time, at which point they may be sold for a profit.

EDIT TO ADD:

Let's take an extremely simple example of company valuation: book value, or the sum of assets (capital, cash, etc) and liabilities (debt, etc). Suppose our company has a book value of $1M today, and has 1 million shares outstanding, and so each share is priced at $1. Now, suppose the company, over the next year, puts another $1M in the bank through its profitable operation. Now, the book value is $2/share. Suppose further that the stock price did not go up, so the market capitalization is still $1M, but the underlying asset is worth $2M. Some extremely rational market participant should then immediately use his $1M to buy up all the shares of the company for $1M and sell the underlying assets for their $2M value, for an instant profit of 100%. But this rarely happens, because the existing shareholders are also rational, can read the balance sheet, and refuse to sell their shares unless they get something a lot closer to $2--likely even more if they expect the company to keep getting bigger.

In reality, the valuation of shares is obviously much more complicated, but this is the essence of it. This is how one makes money from growth (as opposed to income) stocks. You are correct that you get no income stream while you hold the asset. But you do get money from selling, eventually.

Answer 3

One way to value companies is to use a Dividend discount model. In substance, it consists in estimating future dividends and calculating their present value. So it is a methodology which considers that an equity is similar to a bond and estimates its current value based on future cash flows.

A company may not be paying dividends now, but because its future earnings prospects are good may pay some in the future. In that case the DDM model will give a non-zero value to that stock.

If on the other hand you think a company won't ever make any profits and therefore never pay any dividends, then it's probably worth 0!

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Take Microsoft as an example - it currently pays ~3% dividend per annum. The stock has been listed since 1986 and yet it did not pay any dividends until 2003. But the stock has been rising regularly since the beginning because people had "priced in" the fact that there was a high chance that the company would become very profitable - which proved true in the long term (+60,000% including dividends since the IPO!).

Answer 4

As an owner of a share of a business you also "own" profits made by the business. But you delegate company management to reinvest those profits, on your behalf, to make even more profits. So your share of the business is a little money-making machine that should grow, without you having to pay taxes on the dividends and without you having to decide where to reinvest your share of the profit.

Answer 5

Also note that a share of voting stock is a vote at the stockholder's meeting, whether it's dividend or non-dividend. That has value to the company and major stockholders in terms of protecting their own interests, and has value to anyone considering a takeover of the company or who otherwise wants to drive the company's policy.

Similarly, if the company is bought out, the share will generally be replaced by shares in whatever the new owning company is.

So it really does represent "a slice of the company" in several vary practical ways, and thus has fairly well-defined intrinsic value linked to the company's perceived value. If its price drops too low the company becomes more vulnerable to hostile takeover, which means the company itself will often be motivated to buy back shares to protect itself from that threat.

One of the questions always asked when making an investment is whether you're looking for growth (are you hoping its intrinsic value will increase) or income (are you hoping it will pay you a premium for owning it). Non-dividend stocks are a pure growth bet. Dividend-paying stocks are typically a mixture of growth and income, at various trade-off points. What's right for you depends on your goals, timeframe, risk tolerance, and what else is already in your portfolio.

Answer 6

Most companies are taken over. One can reasonably guess that company X will be taken over for a price P, at some future point in time. Then the company has a value today, that is less than price P, by a large enough margin so that the investor will likely "make out" when the company finally is taken over at some unknown point in time.

The exception is a company like Microsoft or Apple that basically grow too large to be taken over. But then they eventually start paying dividends when they become "mature." Again, the trick, during the non-dividend paying period (e.g. ten or fifteen years ago) is to guess what dividends will be paid in some future time, and price the stock low enough today so that it will be worthwhile for the buyer.

Answer 7

Instead of giving part of their profits back as dividends, management puts it back into the company so the company can grow and produce higher profits. When these companies do well, there is high demand for them as in the long term higher profits equates to a higher share price.

So if a company invests in itself to grow its profits higher and higher, one of the main reasons investors will buy the shares, is in the expectation of future capital gains.

In fact just because a company pays a dividend, would you still buy it if the share price kept decreasing year after year?

Lets put it this way:

Company A makes record profits year after year, continually keeps beating market expectations, its share price keeps going up, but it pays no dividend instead reinvests its profits to continually grow the business.

Company B pays a dividend instead of reinvesting to grow the business, it has been surprising the market on the downside for a few years now, it has had some profit warnings lately and its share price has consistently been dropping for over a year.

Which company would you be interested in buying out of the two? I know I would be interested in buying Company A, and I would definitely stay away from Company B. Company A may or may not pay dividends in the future, but if Company B continues on this path it will soon run out of money to pay dividends.

Most market gains are made through capital gains rather than dividends, and most people invest in the hope the shares they buy go up in price over time. Dividends can be one attractant to investors but they are not the only one.

Answer 8

A Company start with say $100. Lets say the max it can borrow from bank is $100 @ $10 a year as Interest. After a years say, On the $200 the company made a profit of $110. So it now has total $310
Option 1: Company pays back the Bank $100 + $10. It further gave away the $100 back to shareholders as dividends. The Balance with company $100. It can again start the second year, borrow from Bank $100 @ 10 interest and restart.

Option 2: Company pays back the Bank $100 + $10. It now has $200. It can now borrow $200 from Bank @ $20. After a year it makes a profit of $250. [Economics of scale result $30 more]

Quite a few companies in growth phase use Option 2 as they can grow faster, achieve economies of scale, keep competition at bay, etc

Now if I had a share of this company say 1 @ $1, by end of first year its value would be $2, at the end of year 2 it would be $3.3. Now there is someone else who wants to buy this share at end of year 1. I would say this share gives me 100% returns every year, so I will not sell at $2. Give me $3 at the end of first year. The buyer would think well, if I buy this at $3, first year I would notionally get $.3 and from then on $1 every year. Not bad. This is still better than other stocks and better than Bank CD etc ...

So as long as the company is doing well and expected to do well in future its price keeps on increasing as there is someone who want to buy.

Why would someone want to sell and not hold one:
1. Needs cash for buying house or other purposes, close to retirement etc
2. Is balancing the portfolio to make is less risk based
3. Quite a few similar reasons

Why would someone feel its right to buy:
1. Has cash and is young is open to small risk
2. Believes the value will still go up further
3. Quite a few similar reasons

Answer 9

Yes, I agree with you. Saying that the value of the stock will grow as the company grows and acquires more assets ... I don't see why. Okay, I'm a nice guy and I want to see other people do well, but what do I care how much money they're making if they're not giving any of it to ME? Frankly I think it's like people who buy commemorative plates or beanie babies or other "collectibles" as an investment. As long as others are also buying them as an investment, and buying and reselling at a profit, the value will continue to go up. But one day people say, Wait, is this little stuffed toy really worth $10,000? and the balloon bursts. Confer Dutch tulips: http://www.damninteresting.com/the-dutch-tulip-bubble-of-1637/

As I see it, what gives a non-dividend-paying stock value is mostly the expectation that at some time in the future it will pay dividends. This is especially true of new start-up companies. As you mentioned, there's also the possibility of a takeover. It wouldn't have to be a hostile takeover, any takeover would do. At that point the buying company either buys the stock or exchanges it for shares of their own. In the first case you now have cash for your investment and in the second case you now have stock in a dividend-paying company -- or in another non-dividend-paying company and you start the cycle over.