What is the intrinsic value of a stock that doesn't give dividends?

Question

From a philosophical standpoint, I'm trying to figure out where the intrinsic value of stock derives from, in the case of a stock that doesn't pay out dividends. That is, what is the value just in owning a stock, ignoring trading it on the market? There must be some reason, otherwise non-dividend stocks would be worthless, but I can't quite get to the bottom of this.

Answer 1

In order to simplify my answer, "stock" refers specifically to common equity. Publicly traded shares which are not common equity entitle their owners to fundamentally different economic interests.

Equity values are based on economic and voting interests in a firm. These rights and interests can vary significantly among publicly traded stocks. In general, common equity is senior claim on ownership and a junior claim on cash flows and assets.

Ownership rights entitle stock holders to vote in corporate actions, annually vote on board members, and bring issues to the board of directors. Traditionally, board of directors are beholden to maximize the value of common shareholders over all other stakeholders, including employees, bondholders, and the general public (although exceptions to this rule are frequent).

Common stock provides the junior-most claim on assets and cash-flows. The claim on assets is relevant in bankruptcy or liquidation during which all senior claims must be paid before stock-holders; stock-holders, however, are entitled to the leftovers (which in a liquidation event usually is not a lot). This contingent claim on assets is represented on the balance sheet as book value; i.e., assets less liabilities. Accounting book value, however, is not necessarily a good estimate of intrinsic and/or market value.

Yet, this results in a chicken and egg predicament. If assets are simply worth the discounted sum of future cash flows, then it stands to reason that stocks are also worth the discounted sum of future cash flows in excess of senior liabilities (or what someone else would pay for them). Thus, the importance of earnings in assessing fair value.

Common stock's junior entitlement to cash flows is realized through either dividends and/or capital appreciation. For example, dividends are the most discretionary business expense; as such, they are paid after all other senior and operating liabilities. Because senior liabilities tend to be relatively fixed, equity-holders are entitled to theoretically unlimited upside if/when the business "strikes gold". However, when a business is not able to meet senior obligations, dividends are the first expense to be cut.

Dividends are not the only way a business can return capital to shareholders. A business can also grow the value of its equity by compounding capital gains (increasing market and/or book value) and returning capital to shareholders through buybacks. According to time value of money concept, investors should be indifferent to receiving the present value of a sum now or the future value at some time in the future. In other words, (assuming no taxes, no slippage, and no fees), a rational investor is indifferent receiving a \$1 dividend and selling his/her stock for a \$1 capital gain within the same holding period.

The time value of money also suggest another important intuition: if a business can compound equity capital more efficiently and at a higher rate than shareholders, investors should prefer that management reinvests earnings rather than pay out dividends. Sic, dividends tend to the least tax efficient way of returning capital shareholders. If/when management believes that it cannot achieve attractive marginal returns on marginal capital invested, only then should it consider paying dividends.

Earnings and expected future earnings, in turn, are the most common proxy for gauging a company's ability to pay dividends and/or compound capital gains.

Thus, stock that does not pay a dividend may still have intrinsic value due to its ability:

• pay dividends and/or finance returns of capital in the future,

• result in capital appreciation through the accrual of earnings (which over time should result in an increase of the market value of book value); and

• sell itself and/or liquidate.

Anyway, that's my take on the philosophical utility of owning shares of common equity. I hope that's useful....

Answer 2

The intrinsic value of a stock is derived from a combination of

• assets on the balance sheet and
• the promise of continued earnings.

Think of a company that has no debt, \$1,000,000 in the bank, and 5000 shares outstanding. Each share has an intrinsic value of \$200 (=\$1M / 5000). (That's if it earns nothing.)

If the company generates a revenue stream, then retained earnings will show up in the balance sheet. Lets say that in the above case, the company earns 10% on its assets. That \$100,000 will eventually end up on the asset side of the balance sheet. The intrinsic value of each share would go up to $220.

Of course steady or increasing earnings are exciting to both researchers and investors, regardless of whether dividends are paid.

To take an example, Apple stock did not pay a dividend before 2012. Was it intrinsically worthless before then? No, of course not. They plowed their profits back into R&D, marketing, and increasing market share. The earnings helped propel the stock higher (much higher than the intrinsic value). For Apple, the promise of continued earnings loomed large.

The classic reference in this arena is The Intelligent Investor, by Benjamin Graham. The author draws the connection between tangible bond interest and less-tangible company earnings.