Have you ever analyzed stocks that don’t pay dividends and wondered why people would ever invest in them?
I used to wonder that too, but after some research, it became pretty clear to me that stocks that don’t pay dividends can still be great investments.
People invest in stocks that don’t pay dividends because of the potential growth of that stock. Companies that don’t pay dividends reinvest their profits back into the business which can often cause a stock to grow. Investors can then sell their stocks for a capital gain and earn more income than they would with dividends.
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For example, let’s look at a company like Amazon.
Amazon is often criticized for not paying dividends to its shareholders, but look at the growth of their stock price over the last 20 years.
Their stock price in October of 2000 was around $30. As of October 27th, 2020, Amazon’s stock is valued at roughly $3,286.
In other words, if you owned $30,000 worth of Amazon stock in 2000, that would be worth roughly $3,286,000.
Hypothetically speaking, if you sold these stocks today, you would have made $3,266,000 off of Amazon’s stock over the last 20 years, despite them not paying a single dividend.
While I understand this is an extreme example, this situation happens more often with non-dividend paying companies.
Non-Dividend Paying Stocks That Have Seen Significant Growth
Investors get rich betting on companies with huge growth potential. These companies are often referred to as “growth stocks”
If you’re still a little confused on why someone would invest money in a stock that doesn’t pay dividends, the next section of this article should help explain things a little more.
How To Make Money From Stocks That Don’t Pay Dividends
There are typically two ways you can make money from investing in stocks, one is from dividends and the other form is through capitals gains.
Capital gain is an increase in a capital asset’s value.
— Investopedia
Put simply, a capital gain is the difference between the buying and selling price of an asset once that asset is sold.
And as you know, stocks such as Amazon, Facebook, Nike, are bought and sold on public stock markets such as the TSX and NYSE.
If you buy a stock for $1 and then sell it for $10, your capital gain is $9.
Simple example, but you get the point.
So, people make money through investing in non-dividend paying stocks through capital gains – selling a stock for a higher price than they bought it for.
Can You Earn Capital Gain Income From Dividend Paying Stocks?
Absolutely you can. Just because a stock pays you a dividend doesn’t mean you can’t sell it for a profit too.
Popular Dividend Paying Stocks
But here’s the thing, dividends are paid out to investors from their after tax earnings.
For example, if a company’s dividend payout ratio is 40%, that means they’re paying out 40% of their after tax earnings back to shareholders.
Payout Ratio = Dividends Paid/Net Income
In one way, that is great for shareholders as they get a piece of the company’s profits, but in another way, it only leaves 60% of company profits to be reinvested back into the business.
The less money a company has to reinvest back into their company, the less they’ll be able to grow and expand their business operations.
If you’re wondering what exactly a business does with their reinvested cash, check out our article called Do Stocks Always Pay Dividends. In this article, we list 7 way in which companies can reinvest in themselves.
Let’s use Tesla as an example.
While it never hurts having Elon Musk on your team, Tesla doesn’t pay dividends so all of the profits are reinvested back into the company to further fund its business operations and become an even more valuable company.
Because of this, Tesla’s stock has seen significant growth over the past year or so. Their stock growth has created MASSIVE returns for it’s investors.
In October of 2019, Tesla’s stock floated around the $50 mark, one year later their stock is over $400. That’s over a 700% return!
I can almost guarantee you this wouldn’t be possible if Tesla decided to payout 40% of their profits to shareholders.
So while you can certainly earn capital gains income from dividend paying stocks, investors looking to generate big returns often prefer to see companies reinvest their profits back into the company for things like funding innovation, creating new products or hiring new employees – just to name a few.
To further elaborate on this concept, here is a video of Warren Buffet talking about why he doesn’t like when companies pay out dividends.
I think he knows a thing or two about investing, right?
Other Reasons To Invest in Non-Dividend Pay Stocks
Now we know the main reason why people invest in shares of a company despite it not paying out a regular dividend.
Companies that payout a portion of their profits to shareholders will have less money to grow their company which could impede the potential growth of their share price.
But here are 3 additional reasons why investors sometimes prefer to invest in non-dividend pay stocks.
Investing for the Long Term
Investors who don’t need income from their investments in the short term are often more inclined to invest in up and coming companies as opposed to established blue chip companies like AT&T.
As you can see from AT&T’s stock chart below, there hasn’t been a lot of growth in their share price over the last 20 years. It has basically hovered around that $25-$40 range for quite some time.
People who invest in companies like this usually do so to receive investment income immediately – in the form of dividends.
AT&T pays out very healthy dividends, which is great for dividend investors, but people looking to make big money returns in the form of capital gains are not investing in companies like AT&T or other established multi-national corporations.
There is only so much these companies can grow!
With all that said, some investors don’t mind their stocks not paying dividends because they’ve invested in this company for the long haul. They are willing to wait 5, 10, 15 years before making any sort of actual return.
Capital Gain Income Can Be Very Lucrative
Why elsedo people choose to invest in non-dividend paying stocks? Because of the uncapped return on investment they can generate.
We already discussed the 700% return Tesla investors would have generated from 2019-2020, but let’s look at another company – Zoom Video.
Quick Note #1 – In order to actually receive capital gains income, you must sell your stock, otherwise it is considered unrealized income.
On January 5th of 2020, Zoom’s stock sold on the Nasdaq for $73.09. As of October 27th, 2020, the share trades for $538.99.
If you owned $7,309 worth of Zoom stock in early 2020, you could have sold it on October 27th for roughly $53,900. In other words, the stock price grew by roughly 637% over a 10 month period.
While the Covid-19 pandemic certainly played a big part in this stock’s price jump, I think you understand what I am trying to get at.
No dividend paying company will be able to generate this type of dividend income for its investors in such a short amount of time. AT&T’s annual dividend yield hovers around the 7% mark, which is high, but it’s a far cry from 637%.
Here’s the thing though, it’s not too risky to invest in blue chip stocks like AT&T, they’ve been around for a while and you know they’re here to stay.
Investing in the next Tesla, Amazon or Facebook? Far from impossible, but much harder and much riskier.
Tax Advantages
For one, you don’t pay taxes on non-dividend paying stocks that appreciate until you actually sell that stock.
Here is a full article explaining why you don’t pay taxes on stocks you don’t sell.
So despite your net worth potentially increasing because of increased stock prices, you won’t owe any taxes on this growth until you realize your gain (sell the stocks).
With that said, you don’t actually receive any cash flow from non-dividend paying stocks until you sell – so there is nothing to be taxed.
But when you do sell some of your shares, you will be required to pay a capital gains tax.
In contrast, any dividends you receive that are held outside of tax friendly accounts such as a Roth IRA, 401k, TFSA or RRSP, will be taxable – even if you reinvest them.
All this to say, people who invest solely in non-dividend paying stocks have more control over when they wish to trigger a taxable event. Unlike dividends – they’re coming whether you want them or not.
Conclusion
While I usually wrap up most articles with a long recap, I will keep this one short.
People invest in non-dividend paying stocks because they would prefer to invest in a company that reinvests their profits for future growth. They believe these reinvested profits will spur future growth of the stock price, which they can then sell for a greater profit.
This type of income is referred to as capital gains. Not only can it be very lucrative, but it can also grow your overall net worth in a tax-free manner.
While companies that do pay dividends can still experience rapid growth (Microsoft), it is less likely as a portion of their profits are being distributed back to investors.
Personally, I invest in both types of stocks.
I love receiving regular dividends for doing absolutely nothing, but I also love cashing out on above average returns in the form of capital gains from stocks that don’t pay dividends. – I did this with Snapchat.
What I don’t love – investing in a company and losing all my money. Luckily I haven’t done this…yet.
Geek, out.
