Is belief in future dividends the only long term value of stock?

Are future dividends the primary value backing that a stock price will rise? (Let's assume that purchase by a competitor is an unlikely event and discount the value this might have).

It seems to me that many stocks are worth astonishingly many times more than their dividends pay, or are likely or even pay. In fact, many companies pay no dividends, and we have no expectation that that they will start paying dividends any time soon. Why buy those stocks?

If your expectation is that their value will go up, it must be because someone else will be will to pay more for it later. However let's imagine even if a company becomes phenomenally profitable, dominates over its competition to an extent that it cannot be acquired, and has lots of cash in the bank, if the company pays no dividends (let's assume its legally bound not to pay dividends for some reason, or has never paid dividends in the past or we have little reason to expect it will pay dividends in the future), where is the value in that stock to a future individual investor?

Disclaimer: There are a lot of interesting aspects to this question. Shareholder voting rights, control over the company, etc. are all interesting things to consider. Here, I only focus on a few parts of the question.

Excess Volatility

Claim: Are actual stock prices much too volatile to be explained by dividends? Is this evidence that the price of a stock depends on more than just future dividends?

It's perhaps not much of an exaggeration to state that the paper that won Robert Shiller his Nobel prize in economics is the paper "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?" In this paper, Shiller looks at historical prices and dividend payments and asks the question, suppose market expectations of future dividends were on average correct? What should the prices of a stock been historically if those expectations were on average correct? He argues that we can do this by looking at the dividend payments and prices and constructing and "ex-post rational price" at each point in time, called $$p^*$$. He then compares that price to the actual historical prices, $$p$$. This is shown if Figure 1 below for the S&P Composite Stock Price index from 1871 to 1979, after detrending both series. The result is that $$p^*$$ appears to be far too smooth relative to $$p$$. He argues that this is a problem because it implies that actual stock prices are too volatile to be explained just by movements in future dividends.

References and other resources:

• Shiller, Robert J. "Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?" The American Economic Review 71, no. 3 (1981): 421-36. Accessed March 12, 2021. http://www.jstor.org/stable/1802789.
• You can view the following online lectures here. This is from "Asset Pricing with Prof. John H. Cochrane. PART II. Module 3. Time Series Predictability, Volatility, and Bubbles" https://youtu.be/mhGQeJyKVvU?t=275

Important Note: In the current asset pricing literature, there is a strong belief that this "excess volatility" puzzle is not a puzzle at all. Empirical and theoretical investigation seems to indicate that this "excess volatility" arises from variation in discount rates. Shiller constructed this ex post ration prices by assuming that the discount rate was constant over time. Empirically, this seems to be far from the truth. For a good discussion of this, see the following:

Rational Bubbles

Claim: Perhaps stock prices can be explained by a belief that prices will continue to grow in the future, even if dividends do not? That is, suppose the price of a stock is not derived from a belief in future dividends but in the belief that prices will continue to growth without bound.

There is a literature that investigates the possible effect of "rational bubbles" on the price of a stock. This is summarized nicely in the "Discount Rates" paper cited about. One way to investigate this question, as described in the Discount Rates paper is to use the Campbell-Shiller (1988) present value identity,

$$dp_t \approx \sum_{j=1}^k \rho^{j-1} r_{t+j} - \sum_{j=1}^k \rho^{j-1} \Delta d_{t+j} + \rho^k dp_{t+k},$$

where $$\Delta d_{t+j} = d_{t+j} - d_{t+j-1}$$, $$dp_t := d_t - p_t = \log(D_t/P_t)$$, $$D_t$$ is the dividend, $$P_t$$ is the price, $$r_{t+1} = \log R_{t+1}$$ is the log return of the asset, and $$\rho \approx 0.96$$ is a constant of approximation. This is an identity based on the definition of returns $$R_{t+1} = (D_{t+1} + P_{t+1})/P_t$$. This says that the normalized prices of an asset ($$dp_t$$) is derived from three possible terms:

1. Future returns on the asset (discount rates)
2. Future dividend growth paid by the asset (cash flows)
3. The future price of the asset (bubble term)

Investigation of the contribution of each of these terms to the volatility of normalized prices indicates the nearly all of the volatility comes from variation in the discount rates term and essentially none comes from the dividend growth and rational bubble terms. This also explains the above "excess volatility" puzzle. Note that this still means that dividend explain the value of a stock. It just rules out that changes in the price-dividend ratio of a stock are not explained by changes in future dividends nor by belief in rational bubble growth in prices.

You can view more of the details of the empirical investigation in the paper or the same videos linked in the previous two section.

Conclusion

The attack against the present discounted value model of stock prices embodied in the "excess volatility" puzzle seem to have an explanation in the fact that discount rates vary over time. An investigation of the contribution of future dividend growth, discount rates, and "rational bubbles" to dividend-price ratios indicates that "rational bubbles" do not seem to explain prices. Rather, dividend yields seem to be entirely explained by discount rate variation. Further investigation seems to indicate that prices and dividends seem to be cointegrated. All of this combined is consistent with the theory that prices reflect the present value of expected future dividends.

However, as noted in my disclaimer above, this leaves open many interesting questions. There is still much to do and learn in this literature.

• Thanks for the very detailed discussion, especially on rational bubbles. I think something that may be missing from a lot of discussion on stock prices is the extent to which stocks are used as a scarce value store, in much the same way people put money into gold or Bitcoin. If we look at the expected future dividends of stocks, it's hard to come away with the opinion that expectations of dividends strongly determine their prices (though it depends on the stock). Mar 15 at 17:13
• @user48956 Thanks. That's why there is a emphasis here on discount rates. And, yeah, I do agree that there is a lot more to the story, as discussed in the disclaimer. Also, if you have any references to peer-reviewed journals, please share. I'm always happy to read and learn more on this topic! Mar 15 at 20:15

Ultimately, yes, in almost all cases, belief in future dividends is the only long term value of stock.

Buy-backs / stock re-purchases only have value because of that belief in future dividends: a buy-back just means that future dividends will be divided across fewer shares, thus higher dividends per share.

There are some corner-case rare exceptions where some of the demand for a stock (and hence some of the market price) may reflect something else, in addition to the discounted value of future dividends; for example:

• I might believe that the company is going to be nationalised, and the State will buy the shares off me at something related to market price.

• I might want to take over the company to achieve returns in other ways: to integrate vertically, horizontally, or laterally - where the goal might be to increase the returns on my current business, rather than getting dividends from the other business. In theory, in a perfect market, those returns ought to be realisable by the takeover target, and available as future dividends, but the market is unlikely to be perfect.

• I might want to take control to achieve ends other than cash returns - for example, I might buy up an exceptionally polluting company and close it down or clean it up in the interests of general well-being.

A stock is a claim on the profit of a company, along with the voting power to control that company and force it to pay out when you want it to. The value of every stock is defined by the payments (from the profit of the firm) the holder expects to get at some point. If the stock pays no dividends, it is because the stockholders have allowed management to plow that profit back into the firm in hopes of greater dividends down the line.

Notice that payments may be in the form of (1) regular quarterly dividends, (2) special one-time dividends, or (3) stock repurchases. All of these are valid ways of taking the profit of the firm and giving it to the owners.

Are there any firms that intend never to pay anything out? No. That would be some sort of non-profit organization.

Metaphorically, think of asking the following quetion: "What if there is a bank account you keep putting money in but that will never allow withdrawals?" The question describes something that is not a bank account. All accounts eventually pay out, whether to the current owner or to one down the line. Similarly all profitable firms will eventually pay out the wealth they have accumulated for their owners. The value of the an ownership claim on the firm (i.e., its stock price) is exactly what people think the future payouts are worth.

Control over a company may also be worth something. A money-losing company can be taken over by a competitor, and the combined company may have increased profits as a result of less competition, economies of scale, etc. The money-losing corporation's share price will reflect the possibility of such a take over.

In addition to dividends, a company may return equity to owners. The taxation of returned equity might be favourable over dividends for the owners in some jurisdictions.

Controlling owner may try to use his position to his benefit in other ways than as being sold or as being a take over target (see Romanchuks answer). Please, consider private equity and an ownership with majority. The major owner may happily collect funds in the form of equity and has plans (and actions) that are not so nice to other minor owners. These include things like well paying managerial job or a well paying customer to other business the major owner owns. I think this is an counter-example to firm intentions in fanrsy's answer.

Some people get value in the form of ESG-matters (environmental, social, governance) by supporting or just being a part of a company whose agenda they believe. Is this slowly increasing tendency (many money managers and investors have considered ESG lately) or just a temporary fashion peak?

Even though the question states that company is not for sale, many stock valuation models consider the value of equity and take into account the residual value of company, for a reason. A company may be sold: there can be a reclaim (or is it redeem?) for the rest of the shares if majority of the owners have already sold their shares. This way the shares will be turned to either money or other shares. This can take place for private and public equity. In this case you should be able to calculate the value of equity (value of assets less debt). A company may be sold in parts, too.

• isn't returning equity to the owners called a dividend? Mar 15 at 12:16
• @user253751 in a way yes, but please do consider the situation, if the money dividend taxation is different compared to returned equity. In these cases it is helpful to be aware of the differencies. (I'm sorry that I'm not able to give you any examples of countries where that would be the case.) Jul 28 at 12:51

As the previous answerer has stated, stocks represent ownership interests in a particular company. Suppose the company in question doesn't pay any dividends. Will owning the company be of value?

Let's suppose it's profitable. It will result in the company having positive retained earnings. Eventually, the company will begin to hold a lot of money. It's valuable just to own that company and take its hoard of money. Owners always have an interest in a company's assets.

• That depends on whether there's a way of realizing a profit from the held assets. Apr 14 '17 at 21:35
• I'm assuming that a profitable business that does not pay out dividends would eventually have an increasingly large amount of cash. Apr 14 '17 at 22:44
• "...and take its hoard of money..." - how, if not by dividends?
– Mick
May 22 '17 at 16:49
• If you have enough of a stake in the company, then you can direct its actions. May 22 '17 at 23:45

The question relies in a bold concept: "long term value". As a good proof of the dubious existence of such concept, your first statement get rid of it, when you ask for "...the primary value backing that a stock price will rise?". If stock price rise is the object to be considered, I find no point in the expression "long term value".

In fact, stock prices are known for being variable, not stable, and it is the rate of that variation which is the typical object of interest and study. And this is, primarily, because the main cause to buy stocks is the hope of future selling them at a higher price, pocketing a profit. That is the most important motivation to buy stocks --overwhelmingly more than the expectation on dividends--.

If we concede that price dynamics depend primarily on the respective strength of demand and supply of stocks, we should ask for the determinants of the willing of buying and selling. In a search for the ultimate factors governing that dynamics -which would take too long here- we'd ask for some "fundamentals" to assess an objective value of the firm --the nearest that we could be to some "long term value"--. In that context, in general, it makes more sense focusing in future firm profits than just in future dividends, which are just the part of those profits paid out to the stock holders. Retained profits, if wisely employed, mean future profits, therefore adding value for its owners.

Accounting identity:

Equity = Assets - Liabilities

Unique Asset Position Model:

Equity = Cash + Securities + Position - Debt

where according to economist Hyman Minsky every unit in the economy holds unique assets, called its "position", and these assets are financed by the mix of equity and debt. Further every unit makes use of position-making instruments in the form of cash, marketable securities, and the ability to issue debt and/or equity claims. Position-making instruments allow the economic unit to hold, keep, and control its position without having to sell unique assets in the position.

Investors can hold debt or equity claims against the assets of the company or firm. So in theory bonds are a substitute for stocks that pay dividends. The main reason to hold equity instead of debt is to earn returns as the combination of capital gains and dividend streams in the future. Equity claims carry more risk because debt claims are superior on available cash flow and assets in bankruptcy.

The position of banks, broker-dealers, and other financial intermediaries is a portfolio of financial assets. These firms make position by issuing liabilities in money and credit markets and hold the debts of other units in the economy. The financial intermediaries are subject to a run, similar to a bank run, when the investors question the quality of financial assets in their portfolio. Dividends may go up for financial intermediaries with high risk portfolios and the stream of dividends may evaporate rapidly if financial intermediaries cannot rollover their short term liabilities in money markets.

Income statement:

Retained earnings = revenue - expenses - dividends paid

Three sources of funds are used to hold the cash, securities, and position. These are debt, equity, and retained earnings. If the firm distributes all profit as dividends it would then have to issue new equity or debt claims to increase its holding of cash, securities, and position assets. So a high growth company usually does not distribute profit as dividends because that would slow the growth of its unique position and reduce its ability to generate future profit streams.

Investors in debt or equity must both look to the position of the company in its unique assets and determine whether or not it will produce sufficient cash flow to service debt, make profits, and distribute some of the profit as dividends. The payment of dividends is subject to discretion of management.

Total return on a stock position is the combination of capital gains and dividends where growth investors expect a firm with growth potential to invest profits into balance sheet growth and their exit strategy is to sell to some other investor for a capital gain. The new buyer may be another growth investor or a value investor who expects the firm to pay dividends and perhaps also grow the balance sheet when the firm has profitable growth potential.