The idea that any investor should buy shares in a company that chooses to not pay a dividend, at first glance, appears to go against the very concept of sensible investing.
Afterall, aren't shareholders meant to receive a share of the profits?
Company shareholders, of course, do share in the success of the business when it does well, even when no dividend is paid.
Over time, growing profits usually result in higher share prices as other market participants buy the shares and bid the price upwards, hence providing a return to the original investor in the form of capital gains.
In this situation, companies that already pay dividends are likely to increase them at least in line with its per-share earnings to keep faith with its shareholders.
But of course, growing profits and appreciating share prices are never guaranteed.
There are two distinct reasons why companies don't pay dividends.
One, a company holds on to the cash it produces as it can generate a higher return if this money is reinvested within the business and not paid to shareholders, or
Two, the company is under financial duress and desperately needs to bolster its balance sheet to ensure debts can be repaid to its creditors.
In the world of investing then, not all companies that don't pay a dividend are the same.
Consider the following two examples.
Origin Energy Ltd (ASX: ORG) and Salmat Limited (ASX: SLM) are companies that both formerly paid dividends to its shareholders: 35 cents in calendar 2015-16 and 15 cents in 2013-14 respectively.
Origin's revenues have essentially remained flat over the last five years leading to shrinking profits and operating cash flows resulting in an interest cover that has shrunk from an already skinny 2.4 times to around 1.3 times.
What this means is that its ability to simply pay the interest bill on its debt had worsened to a point where I think its creditors would have been getting quite nervous without an effort being made by the company to save cash — ie via an elimination of the dividend.
The same can be said for Salmat except the situation was even more dire with an interest cover of under 1!
Unfortunately, since the dividend for each business was cut, there's been no improvement in the company's financials since at least 2015.
The 0% dividend yield of both of these businesses is therefore a clear marker against the investment case for each.
What about companies like XERO FPO NZX (ASX: XRO) and Nanosonics Ltd. (ASX: NAN)?
Both companies have grown their revenues at an average of more than 60% per annum over the last five years and, in Xero's case, has done so without the use of debt.
Nanosonics has debt but its interest cover is a healthy 39 times! That is, its earnings before any interest and taxes is 39 times its annual interest bill — a margin of balance sheet safety I'd be happy with.
Both companies are investing heavily in research and development and have clearly taken the view that they can earn a better long-term return for shareholders if they don't pay a dividend.
Xero isn't profitable yet as it continues to reinvest in itself, and Nanosonics declared a maiden profit in 2015-16 resulting in net interest margins of a robust 40% through calendar 2016.
Foolish takeaway
There are many other examples of businesses that don't pay dividends, but it's important to dig a little and find out why that's the case.
[Another question to ask too is how much new money is being raised via the issue of shares. Clearly, massive dilution in the existing share-count without a similar increase in its earnings-per-share (if profitable) is problematic].
Having pure faith in management's ability to — eventually — earn a net profit from a loss-making position may be considered too risky for some, and investing in the likes of Xero and Nanosonics may prove to be an unsuitable option for certain investors.
Clearly, understanding why a business's financials are structured the way they are requires a little research effort, but buying shares in companies that don't pay — or provide very small — dividends always comes with shareholder optimism that could one day be dashed.
If you don't have the stomach for this, it's probably best for you to avoid nil to low-dividend-paying stocks in the first place, despite the potential long-term rewards.
There are many ways to invest in the market with no one strategy being necessarily right or wrong given variables in investors' ages, temperaments, investment timeframes and the amount of money available to invest.
An alternative strategy to investing in nil to low-dividend-paying companies is, of course, investing in those companies that do pay a reasonable amount of cash to their shareholders. You can discover more about these in our special report which you can obtain by clicking on the link below.
