Compounding without dividends and why shares have value

We recently wrote an article explaining how dividends can compound to grow wealth over the long term.

We explained that compound interest is the interest you earn on interest you’ve already earned. It’s the alternative to ‘simple’ interest, under which your interest earns no interest of its own, and can make small annual returns add up over time. It’s what makes long-term investing so good for your financial health.

If you spend your dividends on more dividend paying shares, then your dividends can compound over time – just like interest.

Compounding with Dividends

But investments can also compound without paying any dividends at all. This article explains how companies can do this, and why non-dividend paying companies can be worth owning in the first place.

Investing in individual companies isn't right for everyone – it's higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you're investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

How to spend it

Companies have a few things they can do with profits or excess cash flow. For our purposes, the two to focus on are:

Consider Amazon, which is a good example of a business which has consistently chosen the second option. Amazon made $57bn after tax last year, and it could do several things with this money.

Amazon could pay dividends to shareholders or buy back some shares. Or it could build more servers for Amazon Web Services, build more warehouses for the retail operation, spend more on research and development, or make some other investment in the business. Hopefully, these investments will pay off and increase profits in the future. These profits could then be used to buy more servers or warehouses etc. which could generate more profits to buy even more servers and so on. Compounding is still at work – it just takes place inside Amazon.

And this is basically what Amazon has done over the last few decades.

Amazon

Scroll across to see the full chart.

Past performance is not a guide to the future. Source: Refinitiv Datstream, cash profits (EBITDA)/shareholder equity, 19/07/21.

Why is a non-dividend paying stock worth any money in the first place?

A share in a company like Amazon would still be worth something if the stock market closed permanently tomorrow. You would likely find it much harder to sell, but the share would still be valuable.

A share represents an ownership stake in a company. As a shareholder, you’re entitled to a share of any profits the company distributes as dividends, and to a share of the proceeds if the company is wound up or sold. The higher and more certain the expected dividends, the more the shares are worth.

If a business is paying dividends, it’s easy to see why it’s still valuable even if it can’t be sold. You can just keep collecting the dividends and earn a return that way. While even uncertain dividends are worth something, remember no dividend is ever guaranteed.

Companies that don’t pay dividends can be valuable for almost the same reason – they might pay dividends in the future.

Take Apple as an example. Apple didn’t pay a dividend between 1995 and 2012. But the shares were still valuable because investors thought it probably could start paying very attractive dividends in the future. Sure enough, for the last few years Apple has been paying out about $14bn every year (and buying back several times that amount of stock).

Dividends vs internal investment

Companies can choose whether to give shareholders excess cash as dividends or invest it internally. But which is better for investors?

The answer depends on whether the business can invest the money at a higher rate of return than investors can get elsewhere for a similar level of risk. If you’re reinvesting dividends to take advantage of compound interest, it doesn’t really matter whether that’s happening within the company or within your account. Ultimately, investors should be looking for the highest rate of return.

You can find out how profitable a company’s historical investments have been by looking at metrics like ‘return on equity’. To calculate this, divide profits by shareholder equity, which you can find in the balance sheet. But remember, this only shows how profitably the company has been able to invest in the past. There’s no guarantee it will be able to do the same going forward. And this shouldn’t be looked at on its own.

If the company looks likely to get a better return on its investments than you could elsewhere, it makes sense for the company to reinvest any excess profits. If it can’t, then you’d probably prefer it to just pay a dividend.

In general, a strong and growing business is one that can reinvest its profits at high rates of return. When a business can’t reinvest at a high rate of return, it should just pay dividends. This is why younger growth companies tend to pay small (if any) dividends and invest a lot internally, but more mature companies often pay relatively large dividends.

Compounding without dividends

Amazon’s share price has risen over the last few decades because its profits have risen – a result of all the highly profitable internal investments they’ve made. More precisely, the business is currently as valuable as it is because investors think Amazon will keep making highly profitable investments and profit will keep rising in the future. Remember though, that’s not guaranteed. Amazon could fail to live up to expectations.

In the end, Amazon’s shares are only valuable because the company could pay massive dividends at some point in the future, once it’s exhausted all its opportunities for highly profitable internal investment. We don’t know how much it will pay or when but, given the $1.8 trillion market cap, investors are clearly expecting a lot.

This article isn’t personal advice. Investments can fall as well as rise in value, so you could get back less than you invest. If you’re not sure if a certain action is right for you, ask for advice.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.