The Equity Advantage: Reinvestment of Earnings

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Equities can compound in value in a way that investments in bonds, real estate, and other asset classes cannot: Companies can distribute anywhere from 0% to 100% of their profits to investors as dividends or share buybacks, while the remaining 100% to 0% can be reinvested in the business. 

S&P 500 firms tend to retain about half their earnings and distribute the other half through dividends and buybacks. This reinvestment of earnings feature is unique to equity investing.

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By comparison, bond owners receive interest payments, but no portion of those interest payments is automatically reinvested back into that same bond or into other bonds. Landlords receive rental income, but that rental income is not automatically reinvested into the property. 

Commodities and cryptocurrencies, among other asset classes, don’t pay cash flows to their owners since they have no cash flows to begin with. Owners can only redirect their investment into other assets by selling all or part of their stake. Thus, an “investment” in these asset classes is merely a punt that the prices will go up due to changes in supply and demand.1

Earnings reinvestment is unique to equities, but that quality alone is not what attracts investors. The appeal is the superior compounding that equities have relative to other asset classes. 

The Median Quarterly ROE of US Nonfinancial Corporations Has Averaged 10.7% over 75 Years

Chart showing Median Quarterly ROE of US Corporations
Source: St. Louis Fed

US nonfinancial companies earn a return on equity (ROE) of around 11%, according to the St. Louis Fed. S&P 500 companies earn an average ROE closer to 13%, according to S&P data. (This is no surprise: The more profitable a company, the more likely it will grow large enough to be included in the S&P 500.) That means if the average S&P 500 company reinvests half its profits at a 13% return, then its profits should grow by 6.5%. The current dividend plus buyback yield on the S&P 500 is 3.5%, according to S&P data.

Stock Buybacks: Motivations and Consequences Tiles

Combining profit growth with the dividend plus buyback yield delivers a 10% expected return from the S&P 500. That’s before accounting for any changes in the index’s earnings multiple or any taxes on dividends or capital gains.

The outcome is even better if rather than the entire index, we own several above-average companies that achieve above-average returns on capital. If we can buy them at an attractive yield on the cash profits they generate and if they can reinvest much of their retained earnings at high rates of return for a long time to come, we may very well outpace that 10% pre-tax, pre-multiple compression (or expansion) return figure.

In fact, we’d rather our above-average companies not pay us taxable dividends at all when they could instead reinvest that money at high rates of return to drive business growth and create shareholder value. 

And let’s not forget, dividends are subject to double taxation (once at the corporate level and again at the individual level), while retained earnings are only taxed at the corporate level.

Depending on the index and time period, long-term US equity returns have ranged from 7% to 10%. So, between reinvesting earnings at 13% or distributing those earnings for shareholders to reinvest in stocks at a 7%-to-10% rate of return, the choice should be obvious. Internal reinvestment is the better bet.

Tile for Equity Valuation: Science, Art, or Craft?

Of course, not all companies have such rich prospects for reinvestment. That’s why the choice to retain and reinvest earnings or pay them out to shareholders depends on four factors, in particular:

  1. The price that the company trades at relative to its future cash earnings potential.
  2. The attractive reinvestment opportunities available to the company.
  3. The expected returns on capital it can generate on those reinvestment opportunities.
  4. The prevailing corporate tax rates and tax rates on dividends vs. capital gains.

If the dynamic among these inputs plays out well, companies should maximize the equity advantage and reinvest their earnings rather than distribute them as dividends or buybacks.

For more on the equity advantage and stock buybacks, in particular, check out Stock Buyback Motivations and Consequences: A Literature Review by Alvin Chen and Olga A. Obizhaeva from the CFA Institute Research Foundation.

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1. Investors in such asset classes are mere speculators in a Keynesian Beauty Contest. Gold can be turned into jewelry and other products and sold. So, there is value in gold. But cryptocurrencies must be sold at a higher price than was paid for them for the investment to be “successful.” Whatever value one investor extracts, another has to pay. Money has changed hands, net of transaction costs, but nothing productive has been delivered.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Nikada

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