Last Updated on July 13, 2021 by Oddmund Groette
In this article, I discuss dividends vs. retained earnings and where the capital compounds best: in your hands or in the company’s hands. Distributions and subsequent reinvestments are an inefficient way of compounding! Given certain assumptions, it’s better to retain the earnings instead of distributing them.
I have written numerous articles about dividends and compounding. To sum up, in order to create the biggest amount of wealth, you would want to invest in a company that has high returns on capital and opportunities to redeploy the earnings into the business at the same returns or close to the same returns (I have provided relevant links at the bottom of this article).
This of course assumes opportunities to redeploy the earnings. If not, then it makes sense to return capital to shareholders.
Dividends vs. retained earnings – an example
Some weeks ago I wrote an article showing the math behind compounding externally (via distributions) versus internally (not making shareholder distributions but redeploying the earnings into the business). The link to the Google Sheet can be found here.
The assumptions are:
- Company A and B are identical businesses having the same growth and returns.
- Both companies grow return on equity (ROE) like clockwork at 10% annually.
- Both companies trade at a price to book (P/B) multiple of two.
However, they deviate in how they allocate capital: Company A distributes 50% of the earnings as dividends, while Company B redeploys all earnings back into the business. Because of this, shareholders of Company A have a hard time compounding compared to Company B (I’m assuming all shareholders in Company A DRIP – ie. reinvest the dividend at year’s end at P/B of 2).
To better illustrate the performance of the share price of these two companies, I made this graph from the Google Sheet:
The red line is an initial 20 000 investment in Company B, the blue line is Company B and the yellow line is Company B after 20% dividend tax. The values after 20 years are like this:
- Company B: 134 500 (10% CAGR)
- Company A: 84 800 (7.5% CAGR)
- Company A including 20% dividend tax: 77 300 (7% CAGR)
A pretty big difference considering the only difference is how they allocate capital! As long as Company B can redeploy earnings at rates higher than 7.5%, it’s a better investment than Company A.
Dividends vs. retained earnings: Why Berkshire Hathaway doesn’t pay a dividend
Berkshire Hathaway has been a fantastic investment precisely because it doesn’t pay a dividend, but redeploy the profits back into the business.
The example above shows pretty why Warren Buffett doesn’t want to pay a dividend. It’s a decision made on rational arguments on how to compound efficiently.
If Berkshire had paid a quarterly or annual dividend, the value would be a fraction of what it is today. Dividend investors might argue a dividend is a way to get rich. I believe long-term Berkshire shareholders know otherwise.
Berkshire has been a huge compounding machine because it doesn’t pay a dividend. I think it pays off to spend some time to understand why Berkshire has not paid a dividend in all those years.
But, as the successful money manager Terry Smith in Fundsmith says:
I don’t think you should ever invest for income. It is a mistake…….. You shouldn’t just invest for dividends, you should invest in businesses that reinvest their profits to achieve a future growth rate…..However, I realise that for many investors, the idea of realising part of their capital to provide income is anathema.
– Terry Smith, CIO of Fundsmith.
Relevant links on how to compound:
- Don’t be fooled by your dividend bias – sell shares to create income
- Don’t be fooled by your dividend bias – marginal rate of return/incremental return
- The foolishness of dividend investing
- Don’t be fooled by your dividend bias – DRIP is inferior to internal compounding
- How much can you pay for a quality company and still make high returns?
- Compounding – the magic of a long-term mindset and delayed gratification
- Why women are better investors than men
- Dollar-cost averaging: a simple and easy way to beat the “experts” and build wealth over time
- Does valuation matter? Less than you think if you buy quality companies
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.