Does it matter if you purchase an Income stock or a Growth stock? Does a company’s decision to distribute dividends or reinvest earnings impact the stock price?

The price of a stock, like any other asset, is derived from the expected future cash flows it will generate. These cash flows are essentially divided into two parts: dividends and capital gains/losses from changes in the asset’s price over time.

Company growth indicates that profits are being reinvested into new machinery, brand development, etc. If no reinvestment occurs, real growth is zero.

If a company is mature, stable, and distributes all of its profits as dividends, its expected return (capitalization rate – Opportunity Cost of Capital) can be described by the formula:

π‘Ÿ=𝐷𝐼𝑉(1) / 𝑃(0)

where 𝐷𝐼𝑉 (1) is the dividend for the next period and 𝑃 (0) is the current price.

Hypothetically, if the company decides to reinvest a portion of its profits into a project with the same return π‘Ÿ, what happens to the stock price? Nothing significant.

The reason is that the Net Present Value (NPV) of such a project is zero. The current loss to investors from reduced dividends is offset by the increase in future dividends.

This concept is illustrated in the photo: if a company successfully invests in a higher-yield project, the stock price increases, and vice versa.

Therefore, in stock pricing formulas, dividends are often replaced by Earnings Per Share (EPS) plus PVGO (Present Value of Growth Opportunities). Thus, the stock price is described as:

𝑃 (0) =𝐸𝑃𝑆 (1) π‘Ÿ+𝑃𝑉𝐺𝑂

Why is this important?

  1. Managers often mistakenly equate next period’s EPS with π‘Ÿ, which is a significant error. This is only accurate if the NPV of new projects is zero. Hence, many companies may be unprofitable, yet their stock prices are positive and often rising.
  2. When valuing a stock or a company’s share, cash flows are divided into two parts: the first while the company’s growth is predictable, and the second after PVGO becomes zero. This second period occurs when market competition is expected, and positive NPV projects are non-existent. Competition drives the market towards zero NPV, which eventually happens in all sectors.

This becomes crucial because companies often have long lifespans and can be seen as immortal entities. Consequently, 60%-80% of their value depends on the period after PVGO becomes zero. Therefore, even a 1% increase in the return rate can significantly impact valuation. This is why embedding growth in the long-term period often leads to errors in projections.

Photo and insights sourced from:

“Principles of Corporate Finance,” 12th Edition by Richard Brealey, Stewart Myers, and Franklin Allen