I recently wrote about why dividends are the ultimate driver of stock valuations. Legendary investor Warren Buffett once said: “Intrinsic value can be defined simply as the discounted value of cash that can be taken out of business during its remaining life.”

And dividends are ultimately the cash that is taken out from a business over time. As such, I consider the prospect of dividends as the true driver of stock valuations.

But what if a company will not pay out a dividend in my lifetime? 

Dividends in the future

Even though we may never receive a dividend from a stock, we should still be able to make a gain through stock price appreciation.

Let’s say a company will only start paying out $100 a share in dividends 100 years from now and that its dividend per share will remain stable from then. An investor who wants to earn a 10% return will be willing to pay $1000 a share at that time.

But it is unlikely that anyone reading this will be alive 100 years from now. That doesn’t mean we can’t still make money from this stock.

In Year 99, an investor who wants to make a 10% return will be willing to pay $909 a share as they can sell it to another investor for $1000 in Year 100. That’s a 10% gain.

Similarly, an investor knowing this, will be willing to pay $826 in Year 98, knowing that another buyer will likely be willing to pay $909 to buy it from him in a year. And on and on it goes.

Coming back to the present, an investor who wants to make a 10% annual return should be willing to pay $0.07 a share. Even though this investor will likely never hold the shares for 100 years, in a well-oiled financial system, the investor should be able to sell the stock at a higher price over time.

But be warned

In the above example, I assumed that the financial markets are working smoothly and investors’ required rate of return remained constant at 10%. I also assumed that the dividend trajectory of the company is known. But reality is seldom like this.

The required rate of return may change depending on the risk-free rate, impacting what people will pay for the stock at different periods of time. In addition, uncertainty about the business may also lead to stock price fluctuations. Furthermore, there may even be mispricings because of misinformation or simply irrational behaviour of buyers and sellers of the stock. All of these things can lead to wildly fluctuating stock prices.

So even if you do end up being correct on the future dividend per share of the company, the valuation trajectory you thought that the company will follow may end up well off-course for long periods. The market may also demand different rates of return from you leading to the market’s “intrinsic value” of the stock differing from yours.

The picture below is a sketch by me (sorry I’m not an artist) that illustrates what may happen:

The smooth line is what your “intrinsic value” of the company looks like over time. But the zig-zag line is what may actually happen.

Bottom line

To recap, capital gains can be made even if a company doesn’t pay a dividend during our lifetime. But we have to be wary that capital gains may not happen smoothly.

Shareholders, even if they are right about a stock’s future dividend profile, must be able to hold the stock through volatile periods until the stock price eventually reaches above or at least on par with our intrinsic value to make our required rate of return.

You may also have noticed from the chart that occasionally stocks can go above your “intrinsic value” line (whatever rate of return you are using). If you bought in at these times, you are unlikely to make a return that meets your required rate.

To avoid this, we need to buy in at the right valuation and be patient enough to wait for market sentiment to converge to our intrinsic value over time to make a profit that meets our expectations. Patience and discipline are, hence, key to investment success. And of course, we also need to predict the dividend trajectory of the company somewhat accurately.

Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.

Our team has spent decades scouring SGX for stocks. And we think dividends could be the answer to rising inflation and market uncertainty in 2023. With our newest FREE report, you’ll have everything you need to find, keep and make more money from dividend stocks. Click here to download it for free.

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Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.