Hi dasickis, no problem. This is a great question because “stocks are good” is something people often assume without thinking about it (myself included). I may turn this into an article after all :).
To simplify things, imagine a company as a “machine” that makes money each year. Turn the crank, money comes out. [In some broken machines, turn the crank and it costs you money… but let’s ignore that ].
Let’s say the machine spits out $1 million each year (after tax, expenses, polishing, etc.). How much would you be willing to pay to own this machine?
Whatever price you pick, there’s a Price-to-Earnings ratio (called PE or P/E). This is the multiple of earnings you pay for an investment. So, while you could pay any amount, you’d likely pay around 10x, or 10 million dollars. That means you paid $10M to get $1M annually, which is a solid 10% investment. The owner may find that price fair, and you’re both happy.
But $10M is a lot. If you can’t afford the entire machine, the owner could split it into a million pieces [shares]. In this case, you’d be willing to pay $10 per share, assuming all earnings are paid out as dividends [$1 per share]. But dividends are “boring”.
Suppose the owner says this: I’ll sell half my machine for $5 million, and keep the other shares to myself. Using this money and the yearly earnings, I’ll do advanced research and development for improvements. By my estimates, in 3 years the improved machine will be spitting out $100 million per year, instead of $1 million.
Wow! Now what would you pay? Probably a lot more than $10 [current value], since there’s the expectation the machine will be cranking out $100 per share in the future. You might pay $40, $100 or $500, depending on how likely you think the prediction is to happen.
After 3 years, and $100M per year [no dividends have been paid yet – all income goes to research], the owner comes to you again. Hey, with even more improvements we can grow to $1 billion dollars per year. Yowza! What do you value it now? $1000 per share? $5000? $10,000?
There’s two forces at play. First, there is the raw dividend: for growth companies a dividend is a bad sign. It means “Hey, I can’t improve the machine any more. Here’s your money.”.
Second, there is the value other people will pay. Shares in a growth stock, to some extend, are only as valuable as what someone else will pay. It’s a little bit like an old comic book; if nobody cares about it, it’s not worth anything [Coconut-man]. But the first issue of Spider-man is quite valuable as a lot of people care.
Shares of a value stock are inherently useful since they return a dividend. Shares of a growth stock depend, on some extent, to being able to sell to someone else down the road. [If it’s a poorly priced stock this is known as the “Greater Fool” theory. I may be a fool for buying at this price, but I can sell to an even Greater Fool later.]
Now, the person you sell to down the road may in fact be a value investor. But if you bought a growth stock for $10, you get to sell it to the value investor for $1000, since the company machine is now churning out that much more money [and the board of directors has decided to start paying dividends].
So, to answer your direct question: Value companies may pay out a large fraction of their earnings in dividends [but it’s unlikely for them to grow from $100 to $200 because they aren’t improving the machine]. For growth stocks, an improvement in profit would raise the stock price [“Yes, the machine is making more! It can sell for higher down the road!”] but not the dividend for the individual investor.
Wow, hope that made sense