Companies that do not pay a dividend retain their earnings. This allows them to use these funds to reduce financing costs and/or to expand their business which can make the company more profitable.
It is a common belief amongst investors that stocks which do not pay dividends will provide stronger returns than stocks that do pay dividends. To a certain extent this tends to be true but this is not always the case.
The following table shows the average gains obtained for the S&P 500 stocks since March 2009 (which was the start of the current bull market) until October 2014.
Table 1. Average Gains for S&P 500 stocks since 2009
Table 1. above splits the S&P 500 stocks into two categories – stocks that pay no dividends and stocks that frequently pay dividends.
It should be noted that the average capital gains calculations assumes that each stock in the S&P 500 index has an equal dollar value within an investor’s portfolio. The calculations were performed this way since most retail investors buy the same dollar amount for each stock, whereas the S&P 500 index calculated by Standard and Poor’s is weighted by market capitalization.
The S&P 500 index gained 188% since the start of the current bull market. The average gain for all stocks in the S&P 500 from Table 1. gained 293% based on equal dollar value. The equal dollar gain is greater that the index gain which is weighted, this means that the smaller stocks in the index gained more than the larger stocks (but this is not always the case). When portfolios contain the same dollar value for each stock irrespective of their market weighting, investors can get a boost to their returns when the smaller stocks perform well.
From Table 1. the average capital gain was the highest for stocks that pay no dividends – which is as expected. But when the dividends paid since March 2009 are included, the total capital gains with dividends included were all about the same.
Thus the returns since the start of the bull market were no better for the non dividend paying stocks. Which just goes to show that buying at the start of a bull market produces good returns no matter what stocks were bought?
But what if the stocks were bought at the top of the previous bull market?
The following table shows the average gains obtained for the S&P 500 stocks since October 2007.
Table 2. Average Gains for S&P 500 stocks since 2007
Table 2. above splits the S&P 500 stocks into two categories – stocks that pay no dividends and stocks that frequently pay dividends.
Similar to Table 1. the average calculations assumed that all stocks are equal size. Whereas the S&P 500 index gained 25%, the average gain for the stocks in Table 2. is 61% based on equal size. Again this shows that the smaller stocks in the index gained more than the larger stocks.
The average capital gain was the highest for stocks that pay no dividends – which again is as expected. Stocks that paid dividends underperformed even after the dividends were included in the returns. Interestingly stocks that paid frequent dividends did provide better returns than stocks that only paid some dividends. This usually occurs when a few dividend paying stocks perform really well which really boost the returns. Investors will drive up the prices of good earnings growth stocks even if they do pay dividends.
Stocks that do not pay dividends generally produce better stock price returns, but this advantage may be lost once the dividends from dividend paying stocks are included in the returns. Simply buying stocks that do not pay dividends does not necessarily mean that the returns will be higher.