Key Points:
- Equities allow for the reinvestment of earnings, unlike other asset classes like bonds, real estate, commodities, and cryptocurrencies.
- Companies can choose to distribute a portion of their profits as dividends or buybacks, while the rest can be reinvested in the business.
- Equities offer the potential for superior compounding due to the reinvestment of earnings.
- The median quarterly return on equity (ROE) of US nonfinancial corporations has averaged 10.7% over 75 years.
- The S&P 500 companies earn an average ROE closer to 13%, which can lead to profitable reinvestment and growth.
- Reinvesting earnings can result in higher returns compared to distributing earnings for shareholders to reinvest in stocks.
- Maximizing the equity advantage through reinvestment depends on factors like price, reinvestment opportunities, expected returns, and tax rates.
Equities have a unique advantage over other asset classes like bonds, real estate, commodities, and cryptocurrencies when it comes to utilizing earnings for reinvestment. Companies can choose to distribute a portion of their profits to investors as dividends or buybacks, while the remaining earnings can be reinvested in the business.
Unlike bond owners who receive interest payments without the ability to reinvest them back into the same bond or other bonds, equity owners can benefit from the compounding effect of reinvested earnings. Landlords who receive rental income also do not have the option to automatically reinvest that income into the property.
Commodities and cryptocurrencies, on the other hand, do not generate cash flows and therefore do not pay cash flows to their owners. Owners of these asset classes can only redirect their investment by selling their stake. This makes equity investing unique in its ability to reinvest earnings for potential growth.
The appeal of equity investing goes beyond the ability to reinvest earnings. Equities have shown superior compounding potential compared to other asset classes. The median quarterly return on equity (ROE) of US nonfinancial corporations has averaged 10.7% over 75 years, according to the St. Louis Fed. S&P 500 companies earn an average ROE closer to 13%, indicating the potential for profitable reinvestment and growth.
Earnings reinvestment becomes an attractive option for investors when considering the potential returns it can generate. If an average S&P 500 company reinvests half of its profits at a 13% return, its profits can grow by 6.5%. In addition, the dividend plus buyback yield on the S&P 500 is currently 3.5%, according to S&P data. Combining profit growth with the dividend plus buyback yield can result in an expected return of 10% from the S&P 500.
Investors can potentially outpace the 10% return figure by focusing on above-average companies that achieve above-average returns on capital. These companies, if bought at an attractive yield on the cash profits they generate, have the potential to reinvest retained earnings at high rates of return for an extended period. This can lead to even greater returns.
In fact, it is often preferable for above-average companies to reinvest their earnings rather than pay taxable dividends. By reinvesting the money into the business, these companies can drive growth and create shareholder value. Additionally, retained earnings are only taxed at the corporate level, while dividends are subject to double taxation at both the corporate and individual levels.
When comparing the potential for reinvesting earnings at a 13% return in equities versus distributing earnings for shareholders to reinvest in stocks with a 7%-10% rate of return, the choice of internal reinvestment becomes clear. Depending on the index and time period, long-term US equity returns have ranged from 7% to 10%, further emphasizing the advantages of reinvesting earnings.
However, not all companies have the same prospects for reinvestment. The decision to retain and reinvest earnings versus distributing them as dividends or buybacks depends on various factors. These factors include the price of the company relative to its future cash earnings potential, the available reinvestment opportunities, the expected returns on capital, and the prevailing tax rates on dividends and capital gains.
In conclusion, equities offer investors the unique advantage of utilizing earnings for reinvestment, allowing for potential compounding and growth. Reinvesting earnings can lead to higher returns compared to distributing earnings for shareholders to reinvest in stocks. However, the decision to reinvest or distribute earnings depends on various factors and the prospects for future growth in each individual company.
