When you look for companies to invest in, you'll find some companies pay dividends regularly to stockholders and provide them with a regular income stream. What happens to companies that don't pay dividends? How does this benefit stockholders? If you invest in a corporation that reinvests its earnings, the business is usually seeking to expand and wants to invest earnings in areas that will grow company sales. When company growth translates into a higher stock price, you will earn capital gains if you sell your stock at a price higher than the purchase price.
Reasons For Reinvestment
A company's decision to reinvest its earnings can be based on a number of reasons. Younger companies reinvest profits to support cash flows needed to pay for current debt and expenses. Reinvested profits can also be used to open new store locations; to perform research on new products or services; to purchase operating assets to be used in the business; or to purchase investment assets. Companies that once paid and have stopped paying dividends may have insufficient cash flow to support a dividend payment, and that may be cause for concern. Slow market or business conditions can also contribute to a company's decision to retain earnings.
Access to Financing
A company’s access to financing can also affect whether earnings are reinvested. The ability to borrow money can be difficult when the cost of borrowing is high, such as when interest rates are rising, or the company can not obtain financing due to financial problems. The reinvestment of profits is important to maintain the company in business and provide it with cash flow to sustain its operating needs or growth objectives.
Effect of Growth Investors
Capital gains are achieved when a company is successful and its stock price is rising. Companies that want to raise their profits and stock price will favor reinvestment of earnings. Growth investors tend to favor companies that reinvest profits. They usually seek to make a profit from capital gains rather than through the receipt of dividend income. As an investor, you have greater chances of earning a higher profit from capital gains than from dividend income. If you are seeking to invest in growing companies, the reinvestment of earnings is one sign that the company probably seeks to grow its sales and increase its stock price.
Effect of Bad Investments
The investment choices made by a company that reinvests its profits can turn out to be unsuccessful. Unprofitable business investments will adversely affect a company and its stock price. Look closely at the current market environment and management’s track record in making sound business decisions to determine if a company is putting its earnings to good use.
Eileen Rojas holds a bachelor's and master's degree in accounting from Florida International University. She has more than 10 years of combined experience in auditing, accounting, financial analysis and business writing.