GeoffF100 wrote:hiriskpaul wrote:True, provided the retained profit can be appropriately reinvested to generate rising earnings, the share price and value of the shares will increase. This is really where compounding is happening. it is the stream of profits that gets reinvested. Reinvesting dividends just puts back the part of the profits that were converted to cash and paid out, to the detriment of share price with each payment.
If the company buys back its own shares rather than paying out dividends, the share price does not fall as it would if a dividend had been paid out, but the remaining shareholders are exactly compensated (ignoring costs) by owning a larger share of the company. The situation then is the same as if a dividend had been paid out and reinvested, except that the shareholder owns fewer shares with a proportionately higher value. Share buy backs are preferable to dividend payments because they avoid withholding tax and dividend tax. Nonetheless, if companies did not pay dividends at all, I expect that the tax rules would change.
In addition to tax efficiencies, Warren Buffett suggests there are additional benefits. Buffett's comment, edited to be £ rather that $ ...
Assume that you and I are the equal owners of a business with £2 million of net worth. The business earns 15% on tangible net worth – £300,000 – and can reasonably expect to earn the same 15% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 150% of net worth. Therefore, the value of what we each own is now £1.5 million. You would like to have the two of us shareholders receive one-third of our company’s annual earnings and have two-thirds be reinvested. So you suggest that we pay out £100,000 of current earnings and retain £200,000 to increase the future earnings of the business. In the first year, your dividend would be £50,000, and as earnings grew and the one- third payout was maintained, so too would your dividend. In total, dividends and stock value would increase 10% each year (15% earned on net worth less 5% of net worth paid out). After ten years our company would have a net worth of £5,187,485 (the original £2 million compounded at 10%) and your dividend in the upcoming year would be £129,687. Each of us would have shares worth £3,890,613 (150% of our half of the company’s net worth). With dividends and the value of our stock continuing to grow at 10% annually.
There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.33% of our shares annually. Since the shares would be sold at 150% of book value, this approach would produce the same £50,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach. Under this “sell-off” scenario, the net worth of our company increases to £8,091,115 after ten years (£2 million compounded at 15%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 35.6% of the business. Even so, your share of the net worth of the company at that time would be £2,880,437. And every Pound of net worth attributable to each of us can be sold for £1.50. Therefore, the market value of your remaining shares would be £4,320,655, about 11% greater than the value of your shares if we had followed the dividend approach. Moreover, your annual cash receipts from the sell-off policy would now be running 11% more than you would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and more capital value.
And that's on a more conservative 1.5x book value share price, more typically that averages around 2x, so scales even more.
When investors sell shares to create DIY dividends when the share price is 2x book value, other people/investors fund that 'dividend' rather than the dividend coming out of the companies bottom line capital. DIY dividends can also be set to the exact amount and timing that fits with each individual investor.
But yes, the US directed more of earnings to be retained when they changed taxation of dividends that made it more appropriate for companies to do so, back in the 1980's (US prior to 1981 and it was illegal for companies to buy back their own shares) . More recently however and the US does seem to be looking at stock repurchases after they exceeded $1 trillion value or so a year back, so as you say the tax/rules could be changed again.