Understanding How Stocks Without Dividends Can Still Have

Value

A common question asked by many new investors is this: if a stock doesn't pay
dividends, isn't buying it sort of like participating in a Ponzi scheme because
your return depends on what the next guy in line is willing to pay for your shares?
That is a very good question and it's important you understand the answer. To
help explain non-dividend paying stocks and how they can benefit your
portfolio, I created the following story to make this some-what difficult topic
easy to comprehend.

Don't forget, though, that dividends are a great source of return for
shareholders, especially when combined with dollar cost averaging. Investing in
non-dividend paying stocks should be the exception, not the rule.

American Apple Orchards, Inc.

Imagine that your father and your uncle decide that they want to start a farming
business. They each contribute $150,000 of their savings to their new company,
"American Apple Orchards, Inc." They file the paperwork with the Secretary of
State, get a business license, and go down to the local bank to deposit the
$300,000 in cash. They divide the company into 100,000 pieces ("shares") at $3
per share, each man receiving half of the stock for his contribution. At this point,
nothing has changed. (They have a company with no assets other than the
$300,000 they contributed to it. They then cut that company into 100,000
pieces. Therefore, each of those pieces represents $3 worth of cash in the bank
account because $300,000 divided by 100,000 shares = $3 book value per
share.)

The new company uses the $300,000 to secure a $700,000 business loan. This
gives them $1,000,000 in cash and $700,000 in debt with a $300,000 net worth
(consisting of their original contribution to the company).

The company buys 300 acres of good farmland at $2,500 per acre ($750,000
total), and uses the remaining $250,000 for equipment, working capital, and
start-up costs.

The first year, the farm generates $43,000 in pre-tax operating profit. After

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 taxes, this amounts to $30,000.

At the end of the year, your father and uncle are sitting at the kitchen table,
holding the Board of Directors meeting for American Apple Orchards, Inc. They
see that the annual report the accountant prepared shows $300,000 in
shareholder equity at the beginning, with a $30,000 net profit, for $330,000
ending shareholder equity.

In other words, for all of their effort, they earned $30,000 on their $300,000
investment. (Note: Instead of cash, however, the assets consist of farm land,
apple trees, tractors, stationary, etc.) That is a 10% return on book value. If
interest rates are 4% at the time, this is a good return. Not only did your family
earn a good return on their investment, but your father and uncle got to live their
dream by farming apples.

Being older men, and wise in the ways of the world, your father and uncle realize
that the accountant left something out of the annual report. (It's not the
accountant's fault; the GAAP accounting rules don't allow him to put it in the
figures.) What is it? Real estate appreciation.

If inflation ran 3%, the farm land probably kept pace, meaning that the
appreciation was $22,500.

In other words, if they sold their farm at the end of the year, they would get
$772,500, not the $750,000 they paid, generating a gain on real estate of
$22,500. GAAP accounting rules don't allow this to show up anywhere. That's
important to understand.

This means that the $300,000 they originally contributed to the company has
grown to $330,000 due to the $30,000 in profits they earned after tax on their
apple sales. Yet, they are also $22,500 richer due to the higher value of their
land, which won't be included due to accounting rules. That means their real
return for the year was roughly $52,500, or 17.5%. (To be fair, you would have to
back out deferred taxes for the money that would be owed if they were to sell
the land but I'll keep it simple.)

The Choice They Face: To Pay Dividends or Reinvest in the Company?

Now, your father and uncle have a choice.

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They have a business that has $330,000 in book value but that they know is
worth $352,500 ($300,000 contributed capital + $30,000 net profit + $22,500
appreciation in land). So, the accountant says their shares are worth $3.30 each
($330,000 divided by 100,000 pieces), but they know their stock is actually
worth $3.52 per share ($352,000 divided by 100,000 pieces).

They have a choice. Do they pay the $30,000 in cash they earned out as a $0.30
per share dividend ($30,000 net income divided by 100,000 shares = $0.30 per
share dividend)? Or, do they turn around and pour that $30,000 back into the
business to expand? If the orchard can earn 10% on capital again next year,
profits should increase to $33,000. Compared to the 4% the local bank pays,
wouldn't they be better off not paying out that money as a cash dividend and
instead going for the 10% return?

Compounding That Dividend Decision for 20 Years

Imagine that this conversation happens every year for the next 20 years. Every
year, your father and uncle decide to reinvest the profit instead of paying a cash
dividend, and each year they earn 10% on capital. The real estate also
appreciates 3% per year. The entire time, they never issue, buy, or sell a share of
their company's stock.

On the company's 20th anniversary, net income is going to be $201,800. Book

value, representing profits poured back into the company for expansion, would
have grown from $300,000 to $2,000,000. On top of that $2,000,000, though, is
the real estate. The land would have appreciated $605,000 from the first day of

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 operation, not one penny of which has ever shown up anywhere in the financial
statements.

Thus, the book value of the company is $2,000,000 but the true value of the
business is at least $2,605,000.

From a book value perspective, the shares are worth $20 each ($2,000,000
book value divided by 100,000 shares). From a "real" value perspective,
factoring in the value of the land, the shares are worth $26.05 each ($2,605,000
divided by 100,000 shares).

If the company were to pay out 100% of its profits in cash dividends, cash
dividends would be just shy of $2.02 per share ($201,800 net profit for the year
divided by 100,000 shares = $2.02 per share cash dividends).

In practical terms, that means that the $300,000 your father and uncle invested
into American Apple Orchards, Inc. when it was founded 20 years ago has grown
to $2,605,000. In addition, the company generates $201,800 in net income each
year. A reasonable, fair valuation of the stock when factoring in real estate
appreciation is $26.05 per share.

Putting It Together

You want nothing more than to go into business with your father. You decide to
approach your uncle and offer to buy his 50,000 shares, representing 50% of the
business.

In the 20 years since the company has existed, not a single penny has been paid
out to the stockholders as a cash dividend. Would you seriously approach your
uncle and offer to buy his shares at the original $3 purchase price when he and
your father founded the company? Or would you offer to buy his shares at their
current value of $26.05?

In other words, if you paid $1,302,500 for 50% of a $2,605,000 farm, do you
really think you'd feel like you were part of a Ponzi scheme because the money
had been reinvested over the years?

Of course not. Your money represents real assets and earning power and you
know that if you wanted to, you could vote to stop growth and start distributing

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 profits as dividends in the future. Even though you haven't actually seen that
money yet, it has represented a real, and tangible, gain in net worth for your
family.

On Wall Street, the same holds true for huge companies. Take Berkshire
Hathaway, for example. The stock has gone from $8 to more than $100,000 per
share over the past 40+ years because Warren Buffett has reinvested the profits
into other investments. When he took over, the company owned nothing but
some unprofitable textile mills. Today, Berkshire owns 13.1% of American
Express, 8.6% of Coca-Cola, 5.7% of ConocoPhillips, 1.1% of Johnson & Johnson,
8.9% of Kraft Foods, 3.1% of Procter & Gamble, 4.3% of U.S. Bancorp, 0.5% of
Wal-Mart Stores, 18.4% of The Washington Post, 7.2% of Wells Fargo, and totally
controls GEICO, Dairy Queen, MidAmerican Energy, Helzburg Diamonds,
Nebraska Furniture Mart, Benjamin Moore Paints, NetJets, See's Candies, and
much more. That doesn't even include the fact that the holding company just
spent $44 billion to buy Burlington Northern Santa Fe.

Is Berkshire worth $102,000+ per share? Absolutely. Even if it doesn't pay out
those earnings now, it has hundreds of billions of dollars in assets that could be
sold, and generates tens of billions of dollars in profit each year. That has value,
even if the shareholders don't get the benefit in the form of cash, because the
Board of Directors could literally turn on the spigot and start paying massive
dividends tomorrow.

In developed nations, with strong financial markets, the stock market will
recognize this gain in value by rewarding a company with a higher stock price. Of
course, this is irregular and can take years. But if you bought $8,000 worth of
Berkshire back in the day, your 1,000 shares are now worth $100,000,000. If you
desired, you could sell off several million dollars worth of stock, or put the shares
in a brokerage account and take a small margin loan against them, to fund your
lifestyle needs. In effect, you could "create your own" dividend.

You could also donate your shares to a charitable remainder trust that will take
your Berkshire, pay you a set return of, say, 5% per year, and then donate all of
the stock to your favorite charity when you die. This is a do-it-yourself dividend
method.

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